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Class \ 1 D ^- ■» : , 

Book ' '^ 

Copyright^? iq i 



CtCEflUGHT DEPOSITi 



PRINTED FOR THE USE OF STUDENTS IN THE 
UNIVERSITY OF MICHIGAN 



PRINCIPLES OF ECONOMICS 



BY 

FRED M. TAYLOR 



FIFTH EDITION 

PREPARED BY 

FRED M. TAYLOR 

AND 

ELMER C. ADAMS 



Ann Arbor 
1918 



#, 



11 



<^,<i 

1^>^ 



Copyright^ 1918 
F. M. TAYLOR 



IN EXCHANGE 



THE ANN ARBOR PRESS 
ANN ARBOR 



PREFACE TO THE FIFTH EDITION 

The principal changes in this edition are the following', 
dividing the chapters so as to make 37 instead of 16 as in the 
fourth edition; elaborating two or three chapters which were 
little more than lecture notes ; abridging two or three discus- 
sions which belonged rather to monograph literature ; dimin- 
ished use of formal principles ; increased use of concrete illus- 
trations; and a general softening of the style. Disproportion 
and inconsistency have been diminished, but not yet removed. 
The most significant single change is the starting of the Crit- 
ique of the Present Order with Distribution rather than Pro- 
duction, — a change which naturally led to a complete reorgan- 
ization of this discussion. 



CONTENTS 

PAGE 

Chapter I — Introductory i 

Chapter II — General Survey of the Existing Economic 

Order 9 

Chapter III— Authoritative Control in the Existing Eco- 
nomic Order 29 

Chapter IV — Analysis of Production 40 

Chapter V — General Conditions of Productive Efficiency ^y 

Chapter VI — Efficiency of Different Factors 84 

Chapter VII — Increase in Output and Rate of Produc- 
tion . 102 

Chapter VIII — Increase in Output and Some Economic 

Consequences . 116 

Chapter IX — Increase in Output and Cost of Produc- 
tion 126 

Chapter X — Money Exchange 140 

Chapter XI^ — Credit Exchange 155 

Chapter XII — Some Elementary Principles with Respect 

to Money 167 

Chapter XIII— Certain Fundamental PrincipJes of 

Trade 177 



vi PRINCIPLES OP ECONOMICS 

Chapter XIV — Price : Preliminary 209 

Chapter XV — Principles Governing the Immediate De- 
termination of Prices 238 

Chapter XVI — Normal Demand Schedules 252 

Chapter XVII — ^Normal Supply Schedules 263 

Chapter XVIII — Principles Governing the Determina- 
tion of Normal Prices 275 

Chapter XIX — Special Cases of Normal Price 293 

Chapter XX — The Theory of Final Price Determina- 
tion 310 

Chapter XXI — Speculative Trading and Insurance .... 334 

Chapter XXII — Principles Governing the Money Stand- 
ard 350 

Chapter XXIII — Principles Governing the Circulation 

of Money 362 

Chapter- XXIV — Principles Governing the Movements 

and Distribution of Money 372 

Chapter XXV — ^Principles Governing the Value of 

Money 386 

Chapter XXVI— The Present System of Distribution. . . 401 

Chapter XXVII— The General Principle of Distribu- 
tion : Corollaries 4^2 



CONTENTS vii 

Chapter XXVIII— Rent 421 

Chapter XXIX— Interest 433 

Chapter XXX— Wages 448 

Chapter XXXI— Profits 462 

Chapter XXXII — Incomes and Forces Outside the Gen- 
eral Distributive Principle 472 

Chapter XXXIII — Critique of Distribution: Proposed 

Substitutes for the Existing Principle 482 

Chapter XXXIV — Defense of the Present System of 

Distribution 499 

Chapter XXXV — Critique of the Process Whereby Pro- 
duction is Regulated 525 

Chapter XXXVI — Critique of Production in Respect to 

Efficiency 535 

Chapter XXXVII — Critique of Consumption 541 



CHAPTER I 

INTRODUCTORY 

One of the most characteristic marks of a sentient being 
Hke man is to have wants, — we might ahnost say that to feel 
wants and secure their satisfaction is the very essence of liv- 
ing. Nov/, the great majority of these wants depend for their 
satisfaction on our disposal over certain material objects or 
conditions — material goods. Hunger can be satisfied only 
by material food, the need for shelter only by material houses, 
the desire for pleasure-riding only by material vehicles. There 
are, of course, some wants^ such as the craving for affection 
from our fellows, or the religious longings, which depend on 
psychological, or at any rate, some sort of immaterial, con- 
ditions. But these are comparatively few ; and even they are 
very closely associated with material things. 

But not only is the satisfaction of our wants dependent on 
material goods, it is further true that most of these material 
goods are obtainable only in exchange for something, — some 
other good relinquished or labor or other form of sacrifice 
supplied. In ordinary language they are said to cost some- 
thing; the economist expresses the same fact by saying that 
they have exchange value — they command a price. Such 
goods are designated generically wealth. They are also called 
economic goods in contrast with free goods, such as air and 
sunlight, which are commonly obtainable without any cost. 

Having such important relations to our lives as it does, 
wealth naturally absorbs a large amount of our time, thought, 
and effort. We are occupied in producing it, in consuming 
it, or in passing it in exchange from one person to another al- 
most constantly. Further, a considerable part of our energies 
are given to preserving it from loss or deterioration. And 
again, our sentiments toward wealth are notable facts of our 



2 PRINCIPLES OP ECONOMICS 

psychic experience ; we prize it, attach a significance to it, 
have a conscious realization of its importance to us, — a fact 
expressed by saying that wealth has individual or subjective 
value. All these and many other facts, happenings, relations, 
connected with ivealth or economic goods, we call economic 
phenomena. These phenomena constitute the subject mat- 
ter of Political Economy or Economics, just as another set of 
phenomena constitute the subject matter of Chemistry, and 
another set the subject matter of Physics. 

The preceding paragraph brought us to something like a 
definition of economic phenomena. That definition, however, 
would need careful limitation. Not all the facts, relations, 
and happenings connected with wealth can properly be in- 
cluded under economic phenomena. On the contrary, much 
the larger part of them belong, in accepted usage, to other sci- 
ences. For example, wheat is of course wealth and gives rise 
to many phenomena which are strictly economic. But it also 
gives rise to phenomena which are physical, chemical, botani- 
cal, and agricultural. In short, things are economic only as 
looked at in one special narrow way. In the very strictest 
sense, they are economic only -when viewed as possessing 
value. 

However, such strict limitation of our field as this is im- 
practicable. First, there are certain very general phases of 
the technological side of wealth which would naturally be 
treated not in such industrial sciences as agriculture, mining, 
or manufacture, but only in some science having a more gen- 
eral character; and, up to the present, political economy has 
been this general science. Secondly, a fair knowledge of these 
technological matters, as viewed from the economic stand- 
point, is absolutely essential to an intelHgent study of the most 
important of the strictly economic problems. In fact, we shall 
find it necessary, as the students of other sciences do, to per- 
mit ourselves rather a wide latitude in the use of this and 
other terms. "Economics" will sometimes include almost every- 
thing connected with wealth. At other times it will be used 



INTRODUCTORY 3 

in the very restricted sense indicated above. In still other 
connections it will have some meaning lying between these ex- 
tremes. 

The foregoing discussion of economic phenomena has 
brought out the point that things are economic only when 
looked at in one special way. But, it should be added that 
there is an economic aspect of many matters which the public 
generally and even many economists are wont to look on as 
quite remote from the field of our study. Thus, the ministra- 
tions of religion seem very far removed from those things 
which are usually thought of as wealth, such as bread, meat, 
or houses. But, in truth, these strongly contrasted things be- 
long in the same class. Bread, meat, and houses have an eco- 
nomic character, not because they satisfy very material, every- 
day wants, but because in view of all the conditions of the 
case they possess value — have to be paid for. And just so the 
ministrations of the clergy have an economic character be- 
cause they have to be paid for. While our science, there- 
fore, has to do with things only on one side, the economic, yet 
on this one side it has to do with almost everything, be it great 
or little, high or low. 

In the fourth paragraph back, we spoke of economic phe- 
nomena as forming the subject matter of Political Economy 
just as certain other phenomena form the subject matter of 
Chemistry, and others that of Physics. We perhaps ought to 
note one point of difference between economic phenomena and 
the others alluded to. The latter belong to a general group 
which are strictly natural, in the sense that they are 
not modified through conditions fixed by men. Economic 
phenomena, in contrast, belong to a group which are in no 
small degree artificial; they are influenced by conditions of hu- 
man origin. Of course all phenomena are natural in the broad- 
est sense of the term. But obviously, some are natural in a 
fuller and deeper sense than others. Now, many economic re- 
lations are among the most truly natural and inevitable that 
can be formed ; many economic phenomena would be just like 



4 PRINCIPLBS OP ECONOMICS 

those we are familiar with in the same connections, even if we 
Hved Hke Crusoes or, at the opposite extreme, Hke a commu- 
nistic society. But, in contrast with these, not a few economic 
phenomena would be very different from what they are now, 
provided that the conditions fixed by men were altered. For 
example, if legal changes were introduced giving the state 
ownership of all the land, the amount of wealth enjoyed by 
many persons would be quite different; if all undertaking of 
production were legally left to the state, more or less conspic- 
uous changes in price would probably take place ; and again, 
if the laws permitted us to own laborers like beasts of burden, 
this circumstance would surely modify many economic phe- 
nomena. It is plain also that such conditions may be brought 
about not only by formal legislation but by custom, conven- 
tion or formal agreements. Thus, a general boycott of manu- 
facturers who employed non-union laborers would be an ar- 
tificial condition of sufficient significance to influence wages 
and employment quite seriously. 

This discussion of natural and artificial conditions should 
now focus in a conception which will be of much importance 
in our future study ; I mean the conception of an economic or- 
der, a system or totality of conditions natural, legal, custom- 
ary, etc., under which economic goods — zvealth — are brought 
into existence, distributed, and consumed. Many such eco- 
nomic orders might be conceived, though there are only a few 
principal types. But our chief business is with the existing 
economic order, the one at present dominant. Our task as 
students of economics is to ascertain the leading facts of this 
order and the principles or natural laws governing economic 
phenomena under it. 

The preceding will suffice to give the student fairly ade- 
quate ideas as to the nature of economic phenomena. It is 
hardly necessary to remark that these phenomena present 
problems of great interest and importance. For some of these 
problems, we shall have to admit, there is not now, and per- 
haps never will be, any complete solution; but others require 



INTRODUCTORY ^ 

only careful and patient study. This perhaps sounds too opti- 
mistic, when we often hear people declare that there are no 
economic principles, that there is no economic science, that 
in economic matters we could not make the smallest predic- 
tion with any hope of its being fulfilled. But such denials 
are not to be taken seriously. Any person can, on the spur 
of the moment, make many predictions in economic matters, 
and look forward to their fulfillment with perfect assurance. 

For example, if there should be a great falling off in wheat 
production next year, the price would certainly rise. If, by the 
introduction of new methods, the cost of producing almost any 
manufactured article were to fall fifty per cent, — monopoly 
being shut out — the price of such article would also fall. If 
the price of aluminum should decline fifty per cent., there 
would doubtless take place a great extension of its use in the 
arts. If the government should begin to coin freely both gold 
and silver, putting only sixteen times as much silver into that 
kind of coin as it does of gold into that kind when on the open 
market an ounce of gold is worth, say, forty ounces of silver, 
the silver would surely get the place of standard money while 
gold would go to a premium and rapidly disappear from cir- 
culation. And so one might go on. In short, economic phe- 
nomena, like any other phenomena, are governed by natural 
laws. If the group of phenomena in question are of such a kind 
that several almost equal forces are interacting, it may be im- 
possible to anticipate the result, just as in complicated natural 
or physical sciences like physiology or meteorology. But, in 
other cases when only one or two of the forces in operation 
are of much significance, it will be comparatively easy to as- 
certain the probable outcome. 

On account of the very great practical significance of eco- 
nomic matters, the student is generally tempted to make im- 
mediate and confident application of every bit of economic 
knowledge which he may acquire. Such procedure is not jus- 
tified in any science ; since, whatever the science one is study- 
ing, some time must be spent acquiring those most general 



6 PRINCIPLES OF ECONOMICS 

principles the actual working of which, though fundamental, 
is, after all, much obscured by the operation of more super- 
ficial forces. In the case of economic phenomena, the too hasty- 
application of fundamental principles to specific problems 
is even less justified than elsewhere, because of the great num- 
ber of economic and non-economic forces, which are simultan- 
eously acting at any given moment and which make the ac- 
curate disentangling of causes almost impossible. It is, there- 
fore, quite important that the student should exercise much 
self-control at this point. In particular, he is urged to sus- 
pend final judgment on almost all great practical problems, 
such as free trade, socialism, trades unionism, etc., till he takes 
courses subsequent to Course i, or anyhow till late in that 
course. This exhortation is the more needed because, in the 
process of trying to secure a thorough comprehension of prin- 
ciples, it seems necessary to make many applications of those 
principles to actual problems. If, however, the student will 
remember that in these applications we are concerned only 
with the economic phase of the problem, while in actual life 
the problem has many other phases, he will realize that he 
should attempt to reach a final opinion, not on the whole 
matter, but only on its economic phase. 

As already implied in the foregoing, the course upon 
which we are just now entering is primarily intended as a 
foundation for later study. It is, therefore, devoted to a se- 
vere discipline upon fundamental principles and their applica- 
tions. In general, our method of procedure is to introduce the 
concrete phenomena needing explanation; then to set forth in 
formal fashion the principle which embodies the explanation ; 
to follow this with adequate illustration and argument; then 
to finish with illustrative problems the solving of which will 
ensure that the student really masters the principle involved. 
We advise that, in preparing the lesson, the student begin by 
reading the text carefully, though not attempting to master 
it; that he then undertake to solve the illustrative problems, 
recurring to the statement and discussion of principles as he 



INTRODUCTORY ' 7 

feels the need therefor ; and that, finally, he go over the entire 
discussion once more in order the better to comprehend it as 
a whole. He can obtain best results from the problems by 
writing out the solution. In doing this, he should not rest 
satisfied with categorical answers even when these seem suf- 
ficient, but rather take pains to explain — give reasons for — the 
conclusion reached. It is essential above all that he cultivate 
clearness and precision of statement and, where argument is 
needed, be careful to include every link of the chain and to 
put each in its proper place. 

Illustrative Problems 

1. "In order to be an economic good — wealth — a thing 
must have utility, — must be capable of satisfying some want." 
Argue for the truth of this statement. 

Answer: The distinguishing mark of an economic good 
is the fact that it has value. But no one will set value on a 
thing unless it is capable of satisfying some want of his; — 
*. e., unless it has utility. Hence to be an economic good, it 
must have utility. 

2. Is air under ordinary conditions wealth ? 

3. Show that in order to be wealth a thing must be ap- 
propriate and transferable. 

4. Is the water flowing from a spring by the roadside 
wealth ? 

5. Is an amiable disposition wealth? A hundred tons of 
gold known to be lying on the surface of the moon? A vein of 
coal existing, but not known to be existing, under a Michigan 
farm? 

6. "If all the whisky, brandy, gin, and other alcoholic 
drinks in existence were taken out and poured on the ground, 
there would not be one whit less wealth or value in the world 
than before the operation." Is that sound? 

7. It would cost a good deal of labor to cover the walls of 
the houses on Washtenaw avenue with posters of a circus given 
two weeks ago. Would the result be wealth? What is the 
point to be made ? 



8 PRINCIPLES OP ECONOMICS 

8. "A thing may have value and not be useful: e. g., an 
old stone prized by a collector." Point out the error. 

9. When we call a man wealthy we mean that he pos- 
sesses a relatively large amount of this world's goods. Should 
we understand this to mean that the possessions of the poor 
man are not wealth? 



CHAPTER II 

GENERAL SURVEY OF THE EXISTING 
ECONOMIC ORDER 

In the introduction we developed, among other things, the 
notion of an economic order — a totahty of conditions under 
which economic phenomena take place ; and we explained that 
our study is mainly concerned with the particular economic 
order now existing, — the phenomena displayed under it and 
the natural laws governing those phenomena. Our first task, 
before undertaking a detailed study of the economic order, is 
to get a general view of it and familiarize ourselves with its 
most conspicuous features. To this task we shall devote our- 
selves in the present chapter and the next. The purpose of this 
chapter can best be attained by associating all our enquiries 
with the one most dominant feature of the existing order. In- 
dividual Exchange Co-operation. 

Section A. The Nature of Individual Exchange 
Co-operation 

Since the purpose, or the ultimate outcome, of the economic 
order is the satisfaction of men's wants, let us make men's 
wants our point of departure in the study of the order. By 
what kind of process or processes do economic goods present 
themselves to different individuals ready for consumption ? 

The general situation in which men find themselves is this. 
They exist, and by the fact of their existence they have wants 
which imperatively demand satisfaction. Further, for securing 
this satisfaction men are themselves entirely responsible; they 
are confronted daily and hourly with the problem of making a 
living. To serve their purpose in making a living, they find 
within themselves a limited capacity for exertion, and they 
find about them a world of material things which in one way or 



lo PRINCIPLES OP ECONOMICS 

another can be drawn upon and utilized. Under these circum- 
stances there are several possible ways in which different indi- 
viduals might be supplied. 

It is easy to imagine an order in which the goods con- 
sumed by each individual would be furnished directly by his 
own efforts. Crusoe on his island contrived the satisfaction 
of his every want by the labor of his own hands, and it is 
probable that many hunters and explorers for a time approxi- 
mate his condition. A pioneer or isolated settler also to a 
great extent produces the very things which he consumes and 
•consumes nothing but what he himself produces — bakes his 
own bread and eats it, grinds his own flour and bakes it into 
bread, raises his own wheat and grinds it into flour. Such an 
order, where each man provides directly and entirely for the 
satisfaction of his own wants, may be called an autonomous 
economic order. 

1. But, as we all know, the actual system is quite different 
■from that above described. We are not acting in economic mat- 
ters independently of one another. We are not producing all 
the things we consume, or consuming all the things we produce. 
Instead, most of the things we consume are produced by others, 
aud most of what we produce is consumed by others. In 
short, the present order is emphatically a co-operative one. 
Co-operation, acting together, pooling in a sense our pro- 
ductive efforts, is the most distinctive fundamental character- 
istic of the present order. 

2. A second special characteristic of our present system 
is found in the peculiar way in zvhich our co-operation is 
'brought about. Ordinarily, in speaking of co-operation, we 
think of it as being conscious, organised co-operation, brought 
about either by agreement or authority. Thus, people co-oper- 
ate in getting up a church supper or picnic, through agreement. 
On the other hand, in the family we have co-operation brought 
about by the authority of one or both the parents, and in com- 
munistic societies — Shakers, Oneida, Amana, — many of which 
have existed in the United States, we have co-operation effect- 



GENERAL SURVEY ii 

ed by the authority of the community. In contrast with such 
conscious, organized forms, the co-operation of the present 
order results from the spontaneous action of individuals in pro- 
ducing goods wanted by other persons, and exchanging those 
goods for goods which the others have produced. That is, the 
element which effects our co-operation under the present order 
is Exchange. This second feature of the order is brought 
out by denominating that order one of Bx change-Co-operation. 
3. A third characteristic of the present order, and one 
which furnishes an additional reason for denominating it an 
order of Exchange-Co-operation, is found in the way our co- 
operation is regulated. It is pretty clear that, if we have any 
co-operation at all, there must be some way of regulating that 
co-operation. We need more of some things than of others. 
We need certain things so much that it will pay us to have 
them even at the cost of going without some other things al- 
together. Unless there is some guiding, directing machinery, 
we shall be wasting our resources producing the wrong things 
or the right things in the wrong proportions. Now, in some 
kinds of co-operation this regulating is done, or would be done, 
by authority. This is the case within the family. How much 
time the farmer's boy shall put in weeding the garden, how 
much splitting wood, and how much picking up stones, the 
farmer determines by authority ; and such a system prevails in 
the main in the communistic societies to which reference 
has already been made. But, throughout most of the present 
order, our co-operation is regidated by the same machinery of 
exchange which effects that co-operation, and in the same spon- 
taneous way. If too little of anything is produced, prices rise 
or the market expands, profits increase, and so producers of 
their own motion increase output ; if, on the other hand, tod 
much of anything is produced, prices fall or the market con- 
tracts, profits diminish, and so producers of their own mo- 
tion diminish output. Again, if the output of some commodity 
during a particular year is exceptionally small, so that con- 
sumption all along the line needs to be curtailed, this is usually 



12 PRINCIPLES OP ECONOMICS 

accomplished, not by the interposition of the pubhc authorities, 
but by an automatic rising of price which induces almost 
every one to cut down consumption of his own motion. So, 
in these and various other ways, exchange regulates our co- 
operation. 

4. We have seen that the present economic order is one 
wherein men co-operate and wherein their co-operation is ef- 
fected and regulated through exchange. The next most prom- 
inent characteristic of the order is individual initiative. It is 
quite possible to conceive a system of co-operation which, in 
part at least, is effected and regulated through exchange, but in 
which initiative is left to society as a whole, government. Thus, 
under socialism as it is commonly advocated, the state would 
be the sole farmer, miner, manufacturer, or merchant, — the 
state alone would undertake to produce things, putting all in- 
dividuals into the position of employees. But it would still 
enter into exchange relations with these individuals, buying 
their services in the open market and selling them its products. 
Further, it very probably would depend on freely determined 
prices to guide or regulate production in the same way that they 
do at present. But, while such a system would, like the present, 
be a system of exchange co-operation, it would differ radically 
in leaving all initiative to the state; whereas, in the present or- 
der, initiative is mostly, though not entirely, the business of the 
individual, — persons who have the means and think they see a 
chance to obtain profits set about producing wheat or iron or 
chairs or what not. Accordingly, to give something like a 
complete characterization of the present order in its most gen- 
eral features we have to say that it is a system of Individual 
Bxchange-Co-operation. 

One point in the foregoing description should perhaps re- 
ceive special emphasis before we pass on. Our affirmation that 
the existing order is regulated through exchange may awaken 
surprise or doubt in some who were unaware that the order is 
regulated at all. Many people have never recognized in ex- 
change the possibilities of a regulating factor; they have as- 



GBNBRAL SURVEY 13 

sumed that the only such factor that could exist is some kind of 
conscious interference; and, knowing that there is little such 
interference in our order, they pass to the natural conclusion 
that our order is almost if not entirely unregulated. Indeed, 
there is nothing more common, even among educated people, 
than the notion that, save for a slight authoritative interference 
here and there, the present order is quite without regulation, 
and therefore exists in a state of chaos or anarchy, governed 
only by chance. Now, this is surely quite contrary to the facts. 
Economic actions are regulated actions. They are organized 
and correlated so as to accomplish uniform and regular results. 
The fact that the regulation is spontaneous, and hence to some 
extent concealed, does not make it any the less real. It would 
be impossible, or at any rate inexpedient, to attempt in this 
place a fuller description of the process by which the regulating 
actually takes place. But the more specific and detailed argu- 
ment for it will be supplied as our knowledge of the economic 
order expands in the progress of this course. 

In saying that the economic order is regulated, we do not 
intend of course to intimate that it is regulated in a manner 
altogether just and expedient. The time has not come to go 
into this topic at all fully ; but even at this stage so much should 
be made clear. No one claims that the present system works 
perfectly, that there are no evils which society ought to try to 
eliminate. There surely are not a few places where spon- 
taneous regulation fails to attain good results, and it surely is 
possible that at these points some other form of regulation 
would do better. But even so, we must still insist that the 
present order is not chaotic, that it is a regulated and a ration- 
ally regulated order, though one in which the process of regula- 
tion is automatic. 

IlIvUSTrative Problems 

1. Give some examples of autonomous production from 
everyday experience. 

2. "Robinson Crusoe, on his far-away island, had neither 
trade nor commerce. Except for the supplies that he recovered 



14 PRINCIPLES OP ECONOMICS 

from the wreck of the ship, he obtained his food from the plants 
that he cultivated and from the wild animals that he killed. 
His clothing was made from the skins of goats ; his table and 
his chairs were the work of his own hands. Even his shelter 
was constructed of the stone and wood that he found on the 
island. If he had more of one product than he needed he could 
not exchange it for other necessary articles. If provisions, 
utensils, clothing, tools, or metals were lacking, he could not 
buy them. He was by turns hunter, fisher, tanner, farmer, 
miller, baker, blacksmith, and carpenter." 

The above is the opening paragraph of a book on Commer- 
cial Geography. It seems intended to suggest the significance 
and importance of commerce by setting forth the disadvantages 
of isolation such as Crusoe's. Put the gist of the matter in a 
single sentence. 

3. "In the main, industry is organized in a spontaneous 
way. Men choose such occupations as they like, and when there 
are too many of them in one group and too few in another, the 
automatic working of economic forces moves them from the 
former to the latter." Explain and illustrate the last clause of 
that sentence. 

4. "The great advantage of foreign trade is in furnishing a 
market for our surplus products which would otherwise go to 
waste." This surely is only a minor advantage of foreign trade. 
Why? Give something better. 

5. If the potato crop of a communistic society which had 
no commerce with 'other communities were to fall off one-half, 
how would they regulate the consumption of potatoes for the 
following year? How is it done under the present order? 

6. "It will never pay us to import anything which we our- 
selves can produce." Show that this proposition is erroneous. 

Section B. Forms and Forces of Individual Exchange 
Co-operation 

To a very limited extent, our co-operation in the present 
order is homogeneous; we combine to do something which 
requires that all shall act in the same general way, as when 
a number of men carry a steel rail. But, generally speaking, 



GBNBRAL SURVEY 15 

our co-operation is heterogeneous. Each person does a dif- 
ferent thing from the rest, though the actions of all may be 
combined and ordered to a common end. But this different- 
iating the tasks involved in the co-operative process and assign- 
ing them to different persons is not something merely occa- 
sional or extemporized. The particular task undertaken by 
each is habitually undertaken by him; he regularly performs 
this task and no other. Now, such a practice is known as 
division of labor or specialisation. And this specialization, as 
one of the most important features of our co-operation, should 
be examined somewhat more specifically. 

I. SpeciaHzation. 

One form of specialization is that wherein each producer is 
entirely responsible for a complete product. Thus the farmer 
plants his potatoes, hoes them while they are growing, and final- 
ly digs and sorts them into bags, ready for the consumption of 
his several neighbors ; while one of those neighbors, the car- 
penter, might draw the plans for a house, procure the lumber 
therefor, and finish the structure complete, ready for the farm- 
er's occupancy. 

But, as every one knows, specialization commonly goes 
much further than this. Practically no one in a highly organ- 
ized society carries from beginning to end the processes neces- 
sary to the production of a finished consumption good. The 
work of the baker in producing bread is preceded by that of the 
miller in producingi flour and that of the miller in turn by the 
work of the farmer in producing wheat. So likewise the work 
of the shoemaker is preceded by that of the tanner, and the 
work of the tanner by that of the stock raiser. Each com- 
modity, in short, comes to its ultimate consumer as a result of 
efforts spent upon it by a long series of different producers. In 
addition, the various members in the original series make use 
of the products and services of producers in various other 
series. Thus the cattle raiser avails himself of the wagons, 
harness and wire fences produced by certain manufacturers. 



1 6 PRINCIPLES OP ECONOMICS 

The tanners again use coal, bark and cloth, and the shoemaker 
uses thread, bristles, needles and machinery, each of which has 
been brought to perfection by as many and various independent 
series of producers. 

But in an economic society so highly developed as ours, 
co-operation and specialization go still further than we have 
yet indicated. In the case last mentioned we were thinking of 
industrial units which, though devoted each to producing only 
a single element in the ultimate product, were yet undivided 
units. It was the stock farm as a whole which we conceived 
of as raising cattle and the tannery as a whole which we con- 
ceived of as preparing hides for leather. But in reality each 
such industrial unit is divided, there is specialization within it. 
In the tannery which as a whole produces leather, some men 
attend to the scraping of hides, some to the curing of the hides 
in the various baths, some to staining, some to finishing, some 
to keeping books, some to writing letters. 

A point with respect to specialization which is much too 
important to be neglected may naturally be presented in this 
connection. Specialization is not limited, as may seem to have 
been implied in the preceding discussion, to human beings. For 
human beings necessarily use lands, machinery, tools in their 
work; and these assisting factors become specialised just as do 
the men themselves. Each tool and machine is more and more 
confined to the performance of one small job; one portion 
of land is devoted to celery, another to onions, another to cit- 
rous fruits, and so on. 

But we have not yet brought out the full extent of co- 
operation under the present order. The speciahzation thus 
far considered grows more especially out of the differences 
in the physical or technical operations to be performed in get- 
ting a product ready for consumption. But there is an an even 
deeper kind of specialization. In speaking of it we shall be 
anticipating somewhat the contents of a later chapter, but the 
broad facts can after all be very easily understood. We already 
had occasion in the last paragraph to mention the fact 



GBNBRAL SURVEY 



17 



that when a man engages in productive operations he does 
not work alone, but brings to the aid of his labor various fac- 
tors outside himself, land and materials, tools, machinery, 
etc. Now, with the development of industrial society under a 
system of exchange co-operation, it has come about that the 
labor for productive operations is furnished by one person or 
class of persons, the land by another, the tools, machinery, etc., 
by another, and the initiative in, or responsibility for production 
by still a fourth. The people furnishing these dift'erent neces- 
sary factors may therefore be said to co-operate. Here, man- 
ifestly, we have a deeper sort of specialization and co-operation 
than anything yet considered. For lack of a better term I will 
designate it as functional co-operation. 

To summarize this discussion : the present economic system 
presents itself to us as one wherein we have a vast complex 
of different industries, mining, stock raising, farming, manufac- 
turing, transporting, etc., each concerned in the production of 
some commodity at one or another stage of completion, while, 
within each of these industries, different functional groups of 
productive agents are co-operating and, while, finally, this vast 
industrial complex is brought together, is held together, and 
is regulated through exchange — buying and selling. The ex- 
isting system is thus seen to be one of extraordinay complex- 
ity, very confusing to the general public and not a little so to 
the trained thinker. It is often difficult to isolate the precise 
function performed by a given business, and people who form 
hasty conclusions are apt to deny the existence of such a 
function, to affirm that the business in question plays no legiti- 
mate part, so that those who pursue it are mere parasites upon 
society. We will do well, however, to assume at the outset ) 
that every occupation not catering to human vice plays a real ^ 
and legitimate role in the total conduct of economic afifairs, is 
doing some one of the numberless things necessary to be done if 
the wants of mankind are to be satisfied in the fullest possible 
measure. 



18 PRINCIPLUS OP ECONOMICS 

2. Competition. 

We have remarked on some important phases of the special- 
ization which forms so vital an element in this exchange-co- 
operation of ours. We must now comment on another very im- 
portant element in the system as at present established, an ele- 
ment which is often thought of as the most characteristic feat- 
ure of the system. That element is Competition. 

To begin with, we need to remind ourselves of the human 
motives at work among men in their specialization which we 
described in the foregoing pages. Each man, we have seen, 
specializes in production, and then brings his product to market, 
where it will be exchanged, and finally consumed by others. 
But while each man produces things for the ultimate use of 
others, his real purpose all along is to secure satisfactions for 
himself. Hence, when he brings his product to exchange, his 
endeavor will be to give just as little to, and get just as much 
from those other people as he possibly can. Such an attitude 
cannot of course be attributed to all men, yet it is common 
enough to form the basis for a general rule. Further, the per- 
son or persons with whom our first man seeks to effect an ex- 
change, are inspired by the same motives as himself. They also 
have a specialized product to dispose of, and they desire to re- 
linquish as little and obtain as much as circumstances will per- 
mit. The two people, therefore, with similar but exactly con- 
trary interests, will enter into a strenuous contest, each to satis- 
fy his own desires at the expense of the other. Put in the 
language of the market, each tries to sell at as high a price, and 
to buy at as low a price as he can. Offers are made on both 
sides and on both sides rejected. New offers are made and 
argued for, and perhaps accepted conditionally; and finally an 
agreement is reached and the exchange is ratified. A contest of 
this kind is what we know as bargaining. 

But in real life this bargaining is not the whole story of 
exchange, or even a large part of the story. In our regime 
of specialization we rarely find one man alone producing and 



GBNBRAL SURVEY 19 

furnishing to the market any particular product. A man may, 
indeed, happen to be the only physician in a thousand miles ; he 
may control all or most of the available wheat, either by hav- 
ing grown it or bought it; or a number of men may have got- 
ten together and pooled their holdings so that, practically, their 
commodity is offered by one individual. But situations of this 
kind are rare — certainly they do not predominate. In our re- 
gime, although men specialize in production, many of them are 
supposed to be producing the same things. They are also sup- 
posed to bring their products to market separately and indi- 
vidually. So they all arrive at the market at the same time 
with the same or similar goods to dispose of. 

Observe now, what happens under these conditions. Sup- 
pose one man has wheat to sell and wants potatoes. He 
will naturally try, as we have seen, to get from those who 
have potatoes as many as he can, while at the same time sur- 
rendering only as much wheat as he must. But now he finds 
himself in company with a dozen or a hundred or a thousand 
other men with wheat to exchange for potatoes, and all as anx- 
ious as himself to give little and obtain much. 

Accordingly, what will the thousand men do? Those who 
are really in earnest about getting rid of their wheat, and those 
who really want potatoes, will compete. Each will try to dis- 
pose of his individual product, and at the same time try to 
acquire the goods which all his fellows alike desire — despite 
the similar efforts of his fellows. And note that now his 
main interest necessarily shifts. He no longer deals with an 
eye single to beating the man on the opposite side of the bar- 
gain. He still holds to his old purpose, of course, but his real 
concern is now not so much with the persons on the other side 
of the bargain as with those on his own side. His concern is 
to crowd in ahead of all other wheat sellers, and sell his own 
wheat and obtain potatoes, in spite of the presence and similar 
efforts of those other wheat sellers. And he must do this, he 
must sell the wheat and get the potatoes ahead of his rivals, 
notwithstanding his fundamental motive and impulse to make 



20 PRINCIPLES OP ECONOMICS 

a good bargain with potato sellers. This rivalry with others 
of a homogeneous group, under the handicap of a bargaining 
motive, is what we call Competition. 

The vital distinction to be made is that between bargaining 
and competition. Competition is not bargaining. You ex- 
change with a bargainer ; with your competitor you do not ex- 
change at all, but rather try to obtain precedence over him in 
your exchange with the bargainer. Neither is competition mo- 
tivated by the bargainer's desire to give little and gain much. 
It is motivated by the desire to dispose of one's own goods and 
to secure the other goods, without reference to much or little, 
in advance of others who are trying to do the same. The fact 
that one desires to gain much and give little — the presence of 
his bargaining impulses — is and can be no other than a hin- 
drance. 

But, now that we know what competition really is, let us 
see what effect it has upon bargaining, and upon the prices 
that would naturally be established by the bargaining process. 
If a man offers to exchange his wheat on very high terms, some 
of his competitors may offer to exchange theirs for less. His 
desire to sell in spite of his rivals will therefore lead him to 
forego to a great extent his selfish desires, and to sell for a low 
price. His desire to buy in spite of his rivals will lead him like- 
wise to forego his selfish desires and buy at a high price. In 
short, he must meet the favorable terms offered by his fel- 
lows or else retire from the field — keeping his wheat and going 
without potatoes. And if he really wants to exchange, he is 
led to sell for approximately as little as any one is willing to 
take, and to pay approximately as much as any one is willing to 
give. 

Without attempting to go more deeply into the subject at 
this point, we now see in a general way that prices in exchange 
are fixed by competition. Hence if, as maintained in an earlier 
section, exchange, or exchange prices are the force that regu- 
late the existing economic order, we must now add that the 



GENERAL SURVEY 21 

prices so operative are prices fixed under conditions of com- 
petition. 

One further point. We laid great emphasis, some time back, 
on the fact that the existing order was co-operative, in the 
sense that men help satisfy each other's wants by producing 
different things and exchanging them. We must now add that 
in a very real sense competition is at the heart of this co-oper- 
ation, that the exchange becomes co-operative only by virtue 
of the fact that it is competitive. Without competition, the 
selfish motives of bargaining would prevail in all our ex- 
changes. Producing apart with the single purpose of securing 
their own fullest satisfaction, buyers and sellers would for- 
ever be at odds, antagonistic to the highest degree, even to the 
point of enmity. But competition neutrahzes this selfish mo- 
tive, reduces it to impotence before the intending bargainers 
ever really come face to face. By an inescapable pressure it 
compels all those on one side to offer to exchange at moderate 
terms, and it assures all these the offer of equally moderate 
terms from the other side. We are thus permitted to satisfy 
our wants reasonably well — as well as most members of our 
group; while at the same time we are compelled to satisfy 
the opposing group reasonably well. In short, through com- 
petition, exchange becomes co-operative almost in a moral 
sense. 

But competition, when we look at it closely, shows itself to 
be an organic part of the co-operative order in yet another 
way. Every participant in the exchanging process hopes to dis- 
pose of his own goods and obtain other goods in spite of the 
presence of his competitors. But, in order to exchange at all, 
one must accept as low prices and pay as high prices as his 
competitors. Now for the individual this necessity may prove 
to be extremely trying. It often costs one man more to turn 
out his products than it costs his competitors, and so if he sells 
as low as they, he may get out of the exchanging process less 
than he puts into it. And if he continues long doing busi- 
ness on any such principle, he will of course come to ruin. 



2a PRINCIPLES OP ECONOMICS 

Now the real difficulty with any individual in this situation 
is that he has not been able to produce the particular com- 
modity which he brings to exchange as efficiently or as cheap- 
ly as his competitors. To save himself, therefore, he will be 
forced to quit that field of production and go out seeking among 
other fields for one in which the advantage does not lie so much 
with his competitors. Only those with independent incomes can 
choose and indefinitely persist in an occupation which does not 
produce something they can sell to advantage. In other words, 
the result of competition, of competitive exchange, is to force 
each person into that field of productive employment for which 
he is best fitted. Specialization, as already pointed out, is an 
essential feature of our co-operative order. Hence, competi- 
tion, which guides our specialization, which leads us inevitably 
to specialize in the employment where we can produce most 
efficiently, which makes our specialization more perfect — is also 
co-operative. Its final result is the more effective satisfying of 
human wants as a whole. 

The most essential points presented in this chapter regard- 
ing the existing economic order, may now be summarized as 
follows : Individuals produce separately, and on their own in- 
itiative, specializing in the production of certain economic 
goods. These goods they then proceed to exchange for goods 
produced by others. And the exchanging process, being carried 
on competitively, results in the fixing of those prices which reg- 
ulate the economic order, and which make it an order truly 
co-operative. 

Section C. Some Economic Principles Deducible from the 
General Nature of the Present Order 

A notable fact, in this stage of general education and en- 
lightenment is the continued acceptance by a great majority of 
persons of quite erroneous notions with respect to several 
familiar and not very difficult economic questions. One can 
hardly run through a current newspaper or popular magazine 



CBN URAL SURVBY 



*3 



without coming upon fallacies which, as the economist looks 
at it, were fully disposed of by Adam Smith almost a century 
and a half ago. This prevalence of unsound doctrine is par- 
ticularly troublesome and dangerous in a country like the Unit- 
ed States, because the majority of the people have power to 
affect the policy of the government in economic matters, and 
frequently assert that power. Accordingly one of the greatest 
tasks of the student of Economics is to train himself in the 
art of detecting the fallacies which lurk in popular beliefs. 
This task confronts us, too, at the very outset of our course; 
for some of the most widespread fallacies are concerned with 
facts already brought out in the foregoing general account of 
the present economic order. We will, therefore, at once set 
about formulating principles and applying them to popular 
errors. 

The first generalization from the nature of the present or- 
der which we have to lay down is that, generally speaking, each 
person gains from the increased efficiency of his neighbors. In 
one way this would seem to follow as an evident corollary from 
the proposition already set forth, that our economic order is 
co-operative. As long as we co-operate in production, the 
efficiency of the persons producing all the different commodities 
will increase ; this will swell the total product of the group and 
so may naturally be expected to bring advantage to all members 
of the group, those concerned with one commodity as well as 
those concerned with another. Thus, when the farmer, carp- 
enter and mechanic co-operate — in the sense that each special- 
izes in his own craft and exchanges his product for those of 
the others — they every one obtain better goods and more goods 
and goods of a greater variety than they otherwise would. 
But in real life there is a more difficult problem. Suppose 
that, after co-operation is established the farmer and the 
carpenter come to a standstill in the development of their craft, 
while the mechanic proceeds to acquire an extreme efficiency. 
It might be argued that, although the aggregate product of the 
group will surely be increased, this will not necessarily be of 



24 PRINCIPLES OF ECONOMICS 

any advantage to the other members of the group, because the 
increase may all go to the person whose efficiency has risen, the 
mechanic alone. 

The full answering of this objection depends on a knowl- 
edge of the principles of price or value which we do not take up 
till later in our study. Still, it will not be difficult to anticipate 
that discussion sufficiently to satisfy the student's mind in re- 
gard to the general point, (i) If the mechanics learn to make 
twenty cars a year instead of ten, while farmers and carpenters 
continue to produce at the same rate as before, then under 
free competition the exchanging rate between autos on the one 
hand and corn and houses on the other will alter in favor of the 
latter. For auto-makers, in competition, will offer more and 
more of their increased supply of cars against a supply of 
corn and houses that has not increased at all. Accordingly, a 
certain quantity of corn and houses will buy more automobiles 
than before. (2) Since by hypothesis no change has taken 
place among the farmers and carpenters, the exchanging rate 
among their goods, corn and houses, will not have altered : a 
certain quantity of one will buy the same quantity of the other 
as before. (3) Consequently, the farmer or carpenter will find 
himself able to buy with his own product more automobiles, 
while buying no less houses or corn. In other words, he will 
have gained from the increased efficiency of another producer. 

It must not be imagined, of course, that the producers 
whose efficiency increases derive no advantage from it. A man 
who suddenly runs far ahead of his fellows in efficiency may, 
before competition can overtake him, reap enormous gains ; and 
the use of secret processes, and the protection of patents may 
for a brief time prolong this advantage. Besides, even when 
competition is operating freely, the efficient producer will real- 
ize some gains. Each unit of his commodity buys less than be- 
fore ; but he has more units to buy with, and usually this brings 
to him an increased total of other goods. The point to be em- 
phasized here, however, is that, although the person or the class 
that shows increased efficiency may gain something by it, the 



GBNBRAL SURVEY 25 

public also does not fail to gain. The benefits of an improve- 
ment do not accrue permanently to the producer alone; they 
are diffused, they go to the public — and, broadly speaking, to 
every member of the public. 

Formulating the point brought out in the foregoing discus- 
sion, we have the following: 

Principle. The present order, being a co-operative one, 
each person or community tends to gain from an increase in 
the economic efficiency of other persons or communities with 
whom or with which said person or community maintains 
economic relations. 

A second matter on which we need thus early to lay down 
a formal principle is the function of trade, exchange. There 
is indeed almost no other phase of Economics on which popular 
opinions go so widely astray. In the minds of a few persons, 
all trade whatever is illegitimate; to a much larger number 
this is true of at least some kinds of trade; and a majority of 
persons, probably, believe that trade, if legitimate at all, is sure- 
ly in any proper sense of the word, unproductive. But if the ac- 
count given in this chapter of the general features of the eco- 
nomic order is sound, all these adverse judgments are of course 
quite untenable. Trade in general and presumably all kinds 
of trade are legitimate because they play a vital, necessary role 
in economic affairs. Exchange is, as we have seen before, of 
the very essence of our heterogeneous co-operation — it both 
effects and regulates that co-operation — and the one without 
the other is unthinkable. The fact may, therefore, be form- 
ulated in the following : 

Principle. Under the existing economic system, exchange 
(trade, commerce) plays an essential part in that it makes pos- 
sible economic co-operation and specialization — it supplies the 
process, or system of processes, whereby co-operation is effect- 
ed and regulated. 

Furthermore, if we understand by the word "productive" 
that the operation so characterized fulfils a condition essential 



26 PHINCIPLUS OP ECONOMICS 

to the satisfying of our wants, then trade in some form, cer- 
tainly, is productive. This proposition so plainly follows from 
the principle that no argument is needed, and it may merely 
be stated as : 

Corollary i. Exchange operations, viewed as processes 
necessary to consummating our economic co-operation, are 
productive operations, and those engaged in such operations 
are producers. 

Another proposition which follows almost as directly from 
the principle may require some little comment. It concerns the 
fact that exchange as a regulator of price is productive. Many 
persons who admit that merchantile operations are productive 
in so far as they are devoted to buying from producers and 
selling to consumers, would yet be disposed to deny the pro- 
ductivity of these operations in so far as they involve the fixing 
of prices. But the error of such a denial can readily be seen. 
Suppose I own an acre of land, and on this land can raise either 
one hundred bushels of potatoes or one hundred bushels of 
onions. But suppose the process of exchange has fixed the 
price of potatoes at $1.50 a bushel, and the price of onions at 
$1.00 a bushel — then certainly I, in view of my knowledge of 
these prices, will raise potatoes rather than onions. In other 
words, the price, regulated through exchange, will regulate my 
economic activities so that the total quantum of values which I 
produce will be $150.00 instead of $100.00. This idea may be 
summarized as a corollary. 

Corollary 2. Exchange operations, viewed as processes 
whereby our co-operation is regulated through price, are pro- 
ductive operations and persons engaged in such operations are 
producers. 

Illustrative Probl^jms 

I. "Give the farmer a parcels post to begin with. Let him 
send his dozen eggs or his pair of chickens direct to the man 
who wants to eat them, or at least to the retail merchant. Cut 
out the commission merchant, the wholesaler, and a few other 



GENERAL SURVEY 



27 



of the city parasites that live on the farmer." — New York 
Evening Journal. 

(a) Suppose yourself to be a farmer living in the neigh- 
borhood of Ann Arbor, and point out some advantages you 
would derive from selling your butter to the grocers and your 
chickens to the meat men rather than to consumers. 

(b) Suppose yourself to be a fruit grower in Western 
Michigan, dependent for your market chiefly on Chicago, and 
point out some disadvantages which you would suffer if you 
tried to sell grapes, peaches, etc., by parcels post to the 
ultimate consumers in Chicago and its vicinity, rather than to 
commission merchants. 

(c) Show that these facts are inconsistent with the notion 
that commission merchants, wholesalers, et al., are "city par- 
asites." 

Note : There is of course much to be said in favor of a 
parcels post ; and it is always possible that the number of mid- 
dlemen should become needlessly large so that some of them 
may fairly be viewed as parasites. But such a characterization 
of the class as a whole is quite illegitimate. 

2. "Internal commerce does not increase the wealth of a 
nation since it only transfers goods from one person to an- 
other." Criticize. 

3. In the natural course of events it often happens that a 
country loses some portion or the whole of its market in some 
particular country. When this happens or is anticipated, public 
men are apt to speak as if such a result involved almost irreme- 
diable disaster. Doubtless it would mean some loss, but by no 
means the amount which people seem to imagine. Explain pre- 
cisely what would be the nature of the injury to us, if our for- 
eign trade should fall off by a considerable amount. Suppose 
our foreign market showed a permanent net shrinkage of 200 
millions of dollars per annum would this mean that our yearly 
income would be 200 millions smaller? If not, just what would 
it mean? 

4. From the Congressional Record for May 17, 1909: 
"Mr. Aldrich. Assuming that the price fixed by the reports is 
the correct one, if it costs 10 cents to produce a razor in Ger- 
many and 20 cents in the United States, it will require 100 per 



28 PRINCIPLES OP ECONOMICS 

cent, duty to equalize the conditions in the two countries . . , 
And, so far as I am concerned, I shall have no hesitancy in 
voting for a duty which will equalize the conditions. " * * * * 

If it was necessary to equalize the conditions, ... I would 
vote for 300 per cent, as cheerfully as I would for 50." 

To what sort of an economic system would such notions, if 
logically carried out, inevitably lead ? 

5. "A first-class illustration of the absurdity and wrong of 
the present order is furnished by the case of a plumbing firm- 
Such a firm does little, if anything, more than act as a middle- 
man between the actual plumbers and householders. But it 
pays the former at the rate of, say, 30 cents an hour for their 
services, while it charges householders 60 cents an hour for 
those services. Here you have a plain case. Either the firm 
underpays the laborers or overcharges the householders ; and 
in either case it gets something which it has no right to. There 
is no other alternative." Discuss the above. 

6. "If the wheat crop of the world should fall oflf one-half 
next year, a rise in price would then be of great social advan- 
tage, in fact, almost indispensable." Explain. 

7. The general account of the existing economic order 
which has been given in the present chapter furnishes one of 
the most fundamental objections to the maintenance of a pro- 
tective tariff, i.e., a tariff intended to hinder our buying goods 
from other countries. Explain that objection. 



CHAPTER III 

AUTHORITATIVE CONTROL IN THE EXISTING 
ECONOMIC ORDER 

We have thus far described the present economic order as 
built up and regulated by the free, spontaneous action of men. 
This description is, in the main, correct ; and it emphasizes the 
fact which we should first of all fix clearly in mind. There is an 
economic order of a perfectly definite sort, organized in a high- 
ly intricate way, and, in spite of its apparent surface contradic- 
tions, tending to supply men's wants with an efficiency truly 
marvelous to those who have never before reflected upon the 
fact ; and this order, in its most essential features, owes its ex- 
istence and its regulation to the free action of men pursuing 
their own personal economic interests. 

In saying this, however, we by no means present a complete 
and accurate picture of the existing order. There never was, 
and is not now, an economic order spontaneous purely. The 
spontaneous action of men in their economic relations has al- 
ways been more or less influenced, either in the way of help or 
hindrance, by authoritative forces outside the men themselves. 
Sometimes mere public opinion or a general social custom has 
made itself felt. Sometimes a powerful religious organization 
has said that men should do thus and so, and has compelled 
them to do it. But the strongest of all authoritative forces out- 
side the individual, especially in the present age, is the action of 
organized government. To this aspect of the existing order, we 
must give something more than passing attention. First, then, 
we take up those governmental activities which may be looked 
on as logically essential to the realization of the principle dom- 
inant in the present order. Later we will remark on several 



30 PRINCIPLES OP ECONOMICS 

kinds of governmental activities which are more or less incon- 
sistent with the central principle of our order, but are, after all, 
by many authorities thought desirable. 

I. Activities Essential to the Realization of the Central 
Principle of the Present Order 

One type of governmental activity vitally essential to the 
present order insures the possession by a considerable number 
of persons of the right of free initiative. This proposition 
is immediately deducible from the fundamental character of 
the present order. That order, we remember, depends on the 
initiative, the spontaneous action, of the individual to see that 
the right things and the right quantities of things are produced ; 
and, at the same time, it expects individuals to exercise this 
function under conditions of competition. Naturally, then, it 
will be necessary for people generally to possess the right of in- 
itiative. Further, since this right might easily be hampered by 
the voluntary action of other individuals, it is necessary that 
the state should make special provision to insure its mainten- 
ance. The government must, for example, do its utmost to 
eliminate what is known as monopoly, — the control by one 
w^ill of economic activity, especially the production or sale of 
any kind of goods. 

Again, governmental action is vitally needed to insure that 
individuals shall have the power to get control of the instru- 
ments of industry, the raw materials, tools, machines, etc., in- 
cluding the services of those human beings who assist in the 
productive process ; for, obviously, production cannot be initiat- 
ed and carried forward by the spontaneous action of individ- 
uals, unless they have this power. Our present economic order, 
in some of its variations, has allowed full property in all these 
factors to the private individual. At times it has permitted him 
to own land, materials, tools, and even the human beings who 
give off productive services. In the present age, as we know, 
property in human beings is almost universally forbidden ; but, 



AUTHORITATIVE CONTROL 31 

in the other instruments of production, it is almost as univer- 
sally recognized. This private ownership is not strictly a ne- 
cessity. The state might own the instruments while the men 
who initiate and maintain production merely buy from it the 
services of those instruments ; and yet the fundamental princi- 
ple of our order would be successfully carried out. In any 
case, however, it would be necessary that individuals should 
have the power named, — the power to control and dispose of 
these services — else they certainly could not initiate and guide 
economic activities. 

But, while men must of necessity have a right to control in- 
struments of production, it is possible that the right will be in- 
fringed by the action of other individuals. Superior force or 
guile may greatly impair the efficiency of the system approved 
by the public will. It follows that governmental action is need- 
ed to insure the possession by the individual of these necessary 
property rights. Whatever degree of control over the instru- 
ments of production we purpose to grant to the individual, that 
control we must insure to him by governmental action. Simi- 
larly, the government should, of course, insure that the man 
responsible for the production of economic goods shall be se- 
cure in his right to the ownership of those goods after he has 
produced them. For other persons might be disposed and able 
to deprive him of the fruits of his efforts, thus destroying the 
motive for industry ; and this possibility can be shut out only 
by the action of the government. 

Another type of governmental action essential to the con- 
duct of the present order is the authorization and maintenance 
of the right of contract. Individuals must be permitted to make 
agreements with one another in respect to their economic con- 
duct, and the government must provide for the enforcement of 
these agreements. This necessity grows out of two facts: (i) 
Many economic operations require extended periods of time, 
and (2) In many cases the carrying out of the time-consuming 
process requires a dependable anticipation of future needs. If a 
man is building a house, he will need material and labor at 



32 PRINCIPLES OF ECONOMICS 

various times during a considerable period in the future ; and, 
for obtaining these, he cannot safely trust to the chance of the 
moment. To secure something like certainty, he makes con- 
tracts in advance. Again, as we all know, one of the chief fac- 
tors in production, capital, it largely obtained by borrowing 
from others. And this involves a contract, in that the borrow- 
er must agree to return the sum borrowed and pay interest for 
its use. 

But, if it is practically necessary to have a right of contract 
in carrying out the principle of the existing order, it is also nec- 
essary at this point to have some action of the government; for, 
without governmental interference, the right of contract could 
not be effectively maintained. Circumstances would always be 
arising in which it was for the interest of one or the other of 
the parties to break the contract ; and all experience shows that 
the temptation is too powerful for human nature unless re- 
strained by the strong hand of the law. Our economic system, 
therefore, requires that the government shall authorize and en- 
force contracts. 

Again, it is plain that governmental authority is needed to 
insure the right of free exchange. As we saw in the preceding 
chapter, one of the most central features of the present order 
is a type of co-operation effected and regulated through ex- 
change. The existence of a general freedom of exchange is, 
therefore, an absolute sine qua non. But this freedom is al- 
ways liable to be infringed by the selfish action of other indi- 
viduals. Dealers themselves are eager to eliminate competition 
and often try to do so by agreements of a monopolistic charac- 
ter. The necessary freedom of exchange, then, can be insured 
only by the potent interference of government. The state may 
conclude that for reasons of a public nature it is, on the whole, 
undesirable to maintain perfect freedom in every field; but it 
should insure such freedom for economic action in general; and 
it should see that no interference with that freedom is permit- 
ted except what it authorises. 



AUTHORlTATlvn CONTROL 33 

2. Activities Designed to Increase Economic 
Efficiency 

We come now to several forms of governmental activity 
which cannot be described as logically essential in carrying out 
the fundamental principles of the present order. They are 
rather interferences with, limitations upon, that principle. They 
have often been opposed by rigid supporters of the present or- 
der, but, in the course of the last century, have notably in- 
creased in all fields. Here we note, first those activi- 
ties which attempt to improve the present order by supplement- 
ing individual action with more efficient governmental action. 
Not a few of this sort have been carried on by government in 
all ages, so that they are looked on by almost every one as be- 
longing essentially to the governmental sphere, for example, the 
issue of the money which acts as a medium of exchange, the 
building of roads, or the making of canals. 

Again, from very early times, government has contributed 
to economic efficiency by granting a form of monopoly known 
as the patent right. Owners of a patent, having the sole right to 
market the product involved, are able to put upon it a price 
which secures a profit above the ordinary ; and so stimu- 
lus is given to discovery and invention. With the same end in 
view, government often confers bounties or prizes for improve- 
ment in productive processes. 

Another type of activity contributing to the efficiency of 
production which has greatly increased in our day, is the con- 
duct of investigation into the conditions and methods of proce- 
dure necessary to highest technical efficiency. Thus public bu- 
reaus are maintained to carry on research in biological subjects, 
like the breeding and care of animals, the improvement of 
seed, the discovery of better conditions for growth, etc. An 
activity closely allied to this last is the dissemination of infor- 
mation among those engaged in an industry, most conspicu- 
ously those engaged in agriculture. Still another consists in 
providing for technical education and training, through schools 
of agriculture, mining, manufacture, and commerce. 



34 



PRINCIPLES OP ECONOMICS 



3. Activities Designed to Alter the Distribution of 
Property and Income 

It has always been recognized that the present system needs 
to be supplemented by governmental action not only to in- 
crease its efficiency, but also to prevent undesirable conse- 
quences w^hich the free working of the system would inevita- 
bly produce. One such consequence is the extreme inequali- 
ties in respect to the distribution of property and income. In 
spite of the high efficiency of the system as a whole, many peo- 
ple feel that we cannot rest content until we have ameliorated 
the inequality resulting from it. And at this point the interven- 
tion of government is demanded. 

The type of interference in question is sometimes described 
as determining the plane of competition. Competition, as 
we have seen, is in a sense the central feature of the present 
order, and it accomplishes extremely valuable results. By all 
means, therefore, competition should be retained; but at the 
same time we should try to put it on a higher level, to raise the 
standards controlling it, to determine, in the interest of larger 
social results, the scope within which it shall act. 

Among the various policies used by government to im- 
prove the system of distribution, we have the guidance of 
taxation in a way to throw the chief burden on the wealth- 
ier classes. In other fields, a particular kind of service is sold 
to every one at the same price, — the rich man and the poor 
man pay the same for a loaf of bread or a pound of meat; 
but the contribution made by rich and poor to the support of 
government, an institution supplying them with many of the 
most important services, are very different in amount. Gen- 
erally, these contributions to public needs are made in accord 
with the paying capacity of the citizen ; and this policy, mani- 
festly, is in effect a re-distribution of the social income. 

In speaking above of the attempt to relieve less wealthy 
people of the tax burden, we had in mind especially that vol- 
ume of taxes which is hoimd to be levied because it is des- 
tined to meet the necessary expenses of government. A sec- 



AUTHORITATIVE CONTROL 35 

ond method of diminishing inequality also involves the sys- 
tem of taxation, but in a different way. Government under- 
takes to improve the condition of people of small or mod- 
erate means by furnishing certain services and goods either 
gratuitously or at a price lower than would appear under the 
operation of free private initiative; and the funds needed to 
meet the expense for these types of activity, like the ordinary 
income of government, are raised by taxation, assessed accord- 
ing to wealth; so that the net result is a re-distribution of in- 
come favorable to all but the wealthy classes. 

The most familiar example of this kind of governmental 
interference is found in the field of education. Poor people 
lack money to give their children an education; the state un- 
dertakes to provide it for them. In respect to the simpler forms 
of education, this policy dates back a long way ; but in our 
day it has been extended also to the more advanced forms. 
Intermediate, and even the very highest cultural courses, 
as also technical or vocational training, are open to all 
classes, if not gratuitously, at least below cost. The children 
of the poor, as a result, have opportunities many times greater 
than they could expect in an order purely spontaneous. Sup- 
posing their natural endowment adequate, they may hope to 
attain the highest professional positions of all sorts.* 

Another line of governmental activity concerned with bet- 
tering the condition of the poorer classes and so in effect re- 
distributing the social income, looks after defectives, — the 
maimed, the blind, the insane, the feeble-minded, — either in 
part or in whole at public expense. The wealthy could afford 
to provide for this themselves, the poor could not. Again, the 
government often manages certain industries which furnish 
fundamental necessities such as water, gas, and electric cur- 
rent, in order to help the poor by supplying these at lower 
prices than would appear under private initiative. In Europe 



* The student is of course aware that much of this sort of work 
is done by the voluntary contributions of the rich; but we are here 
concerned only with the activity of government. 



36 PRINCIPLBS OP BCONOMICS 

a number of municipalities have gone so far as to undertake 
the running of street car lines, charging fares, especially for 
workingmen, below the cost of the service. Still again, gov- 
ernments improve the condition of the less well-to-do by main- 
taining institutions for supplying all classes with forms of 
entertainment which would naturally be open only to the 
rich. This is illustrated in the maintenance of free public li- 
braries, picture galleries, opera houses, parks, and play grounds. 

4. Activities Designed to Guard the Sociah 
Group as a Whole 

In the last section we dealt with activities designed to im- 
prove the condition of the poorer classes. All such activities 
may be and doubtless are inspired in part by another motive, 
the desire to improve the condition of the group as a whole — 
the city, the state, the nation. For surely any group which 
hoped to prosper as a whole would see to it that taxes were 
levied with relatively less weight upon the poor, that defec- 
tives were cared for, and that education for all was provid- 
ed. The foremost motive in all these activities, however, is 
perhaps the welfare of the classes or of the individuals who 
are directly aided. We come now, on the other hand, to a 
type of activity motivated mainly if not entirely by the de- 
sire to improve the welfare of the group as a whole ; a type 
intended not to guard the individual, but to guard the group 
against the evils which might result from the unhindered work- 
ing of the present system. It may be true, as has been im- 
pHed in much of our earlier discussion, that for all individ- 
uals everywhere an absolutely spontaneous, automatic work- 
ing of things would be on the whole, best. In that case a man 
whom we should describe as thoroughly cosmopolitan in spir- 
it, one who is interested in all humanity, would find in such 
regulation the highest possible ideal. But this description ap- 
plies to very few of us indeed. Oftentimes we are not in- 
terested in the welfare of individuals everywhere, nor even in 
our own immediate welfare, or in that of people directly de- 



AUTHORITATIVE CONTROL 37 

pendent upon us^ so much as we are interested in the success 
and greatness of the city, state, or nation to which we belong. 
Further, the welfare of an individual does not necessarily 
consist with that of his group ; there is a possible antithesis 
between the welfare of individuals constituting a group and 
that of the group considered as a whole. Hence, if any group 
of men come to believe that the free, automatic regulation of 
economic relations between their own group and other groups, 
(although best for them as individuals and for all individuals 
everywhere) hinders the accomplishment of some greatly im- 
portant good for their own group, they will naturally insist 
upon interfering with this automatic regulation, and insist on 
resorting to conscious control through the power of the state. 

The chief application of the idea just set forth arises in 
connection with the problem of maintaining the independence 
and power of the nation over against its neighbors. The ef- 
ficiency of a state at this point manifestly depends on eco- 
nomic as well as on purely military considerations. A nation 
needs to be wealthy; it needs to have great capacity for the 
production of the instruments of war; it needs to be in- 
sured the forthcoming of the fundamental necessities of life 
in case it should through the fortunes of war be cut off from 
its usual sources of supply. Now it is perfectly possible that 
the spontaneous working of economic forces should result in 
neglect in some of these fields. The natural resources of the 
nation may be chiefly agricultural; so that the unrestricted 
pursuit of private gain may hinder the nation from develop- 
ing the manufacturing industries and so render it unprepared 
to supply itself with the manufactured goods needed for war. 
On the other hand, it may naturally be an exclusively manufac- 
turing or commercial nation, obtaining its supplies of food from 
other countries. The pursuit of private gain may then fail to 
develop sufficiently some industry on which its very life de- 
pends. 

The possibility that unrestricted private initiative may 
thus expose a nation to complete destruction if cut oflf by war 



38 PRINCIPLES OP ECONOMICS 

from its ordinary sources of supply has led governments to 
put high taxes on the importation of foreign goods, thus rais- 
ing their prices and so making more profitable the producing 
of similar goods at home. Legislation has been used, Hkewise, 
to develop important forms of manufacture; so that we find 
almost all nations erecting tariff barriers to shut out the prod- 
ucts of their neighbors and stimulate the home pursuit of the 
same industries. 

We have commented on those activities of the state which 
are designed to protect the group as a whole against other 
groups by avoiding the economic weaknesses likely to result 
from individual action in economic matters. Another set of 
injuries growing out of individual liberty is associated with 
the dissipation of our primary resources in land, raw materials, 
etc. Experience has shown that private self-interest cannot 
be trusted to conserve the stores of coal, iron ore, copper, oil, 
and timber which constitute, so to speak, the patrimony of the 
nation. It is essential, therefore, for the welfare of the na- 
tion as a whole, that government should step in with a policy 
of conservation, well planned and strictly enforced. Simi- 
lar to this case and even more important is the conservation 
of the life, health, and strength of the people themselves. Un- 
restricted private freedom in business has meant an exploita- 
tion of the strength and capacity of working people, especially 
women and children, quite inconsistent with the welfare of 
the group as a whole. As a consequence, there has developed 
through a century of agitation and legislation a great body of 
statutes designed to guard the productive population against 
the evil effects of excessive and unsuitable labor in unsani- 
tary conditions. 

To sum up the contents of this chapter. Upon the eco- 
nomic order described in the last chapter as one of co-opera- 
tion automatically effected and regulated by exchange, we find 
at many points the influence of conscious regulation directed 
by government. Certain activities of government in enforc- 
ing the right of free initiative, private property, contract, and 



AUTHORITATIVE CONTROL 39 

.exchange, are necessary to allow the automatic principle to 
work itself out in any really effective manner. The govern- 
ment can also interfere in various ways to make the opera- 
tion of the principle more effective than it would naturally be. 
Further, government may and does interfere at some points in 
contradiction to the principle, thereby improving the condition 
of certain classes and enhancing the power of the nation. 

The emphasis we have put upon these modifications should 
not, however, lead us to overlook the fact that they are, after 
all, modifications and that only. The great essentials of the 
economic order at present existing are not these things but 
the things we described in the last chapter. The present order 
is in the main one in which, through the spontaneous action 
of the individual, pursuing his immediate self-interest, there 
arises co-operation of a highly advantageous sort, effected and 
regulated by exchange. It is that spontaneously developed or- 
ganization or, better, organism, which constitutes the real 
framework of our system. And it is that organism which in 
the further study of this course we should keep most prom- 
inently in mind. 



CHAPTER IV 

ANALYSIS OK PRODUCTION 

The central fact of economics, as heretofore pointed out, 
and the starting point for all thinking on economic matters, is 
man's wants. These wants, as we have also seen, are supplied 
by things called economic goods, which take the form either 
of commodities or services. Now, a very little reflection will 
convince anyone that practically all economic goods become 
possessed of their capacity to satisfy wants through the ac- 
tion of men. Fish may grow in the sea and fur on the ani- 
mal's back and trees in the forest ; but, strictly speaking, these 
objects do not become commodities suitable for application to 
our wants till they have been appropriated, shaped, and other- 
wise worked upon by forces directly manipulated by man. 
The same is even more obviously true of services, for in case 
of something like a lecture or a song, the very substance of 
the thing which gives satisfaction appears not to come into ex- 
istence until the lecturer or singer puts forth his effort. This 
process of preparing goods for the satisfaction of wants is 
called production. Accordingly, since our wants are so ur- 
gent and since nearly all goods are necessarily so prepared, 
production must be recognized as one of the most important 
divisions of the study of Economics. 

Section A. What Is It to Produce? 

To begin with, what do we mean by the term "produce?" 
In everyday language, the word is used in several different 
senses, some of which are very broad, and some quite nar- 
row; and in the present study, we may at times allow our- 
selves a similar freedom. In the interests of clear exposi- 
tion, however, it is best at the outset to adopt a meaning which 



ANALYSIS OF PRODUCTION 41 

we shall expect to have in mind when we speak, as economists, 
with the strictest scientific accuracy. 

And first, we shall not usually have in mind, except possi- 
bly as supplementary or illustrative data, any of the details 
of technical production. The study of production undertaken 
by economics is not of course an exhaustive one. Much the 
larger part of what might be said under this head is rele- 
gated to technical sciences and arts such as Engineering, Ag- 
riculture and Mechanics. Economics limits its study of pro- 
duction to certain most general aspects, especially those hav- 
ing very close relations to the problems which form the heart 
of Economic science, the problems of value. The economic 
meaning of "produce" which will be oftenest used in this 
course and which probably has most vogue among present 
day economists is the following: 

To make any contribution to the satisfying of human 
wants, whether this be done by persons or things, providing 
such contribution has a value or price. 

Two qualifications are here stated — that the contribution 
made must assist in satisfying human wants, and that it must 
have a value or price — in other words, must have an eco- 
nomic character. In the light of previous discussions we 
shall need few words to justify the second of these qualifica- 
tions. We are studying economics, not physical science. The 
sort of production we are concerned with is economic, not 
physical production. But economics, as such, takes account 
only of those things which have value or price, and according- 
ly our definition of economic production is restricted to acts 
or conditions which have a price. 

The first part of our definition will require more careful 
examination. Any valuable act or thing that makes a contri- 
bution to human wants is productive, but what do we mean 
by making a contribution to human wants? Since wants are 
all supplied, in the last analysis, through material goods, it 
must mean to be responsible in some sense or degree for the 



42 PRINCIPLES OF ECONOMICS 

existence of material goods haying the quahties essential for 
our satisfaction. But, to pursue the question further, how 
can a man be responsible for the existence of any material ob- 
ject of want-supplying qualities? He cannot create the ulti- 
mate substance of an object, for all matter exists and always 
will exist in some form without his will or sanction- His con- 
tribution must, therefore, consist merely in bringing substan- 
ces or materials which already exist into such a condition that 
they are capable of satisfying wants. Hence, since the capacity 
to satisfy wants is called Utility, we may say that to produce is 
to create utilities — the contributing act or thing being always 
understood to have value. 

The emphasis laid on utility in the above analysis makes 
desirable some further comments on this term. First, as the 
word is employed by economists it includes many different 
kinds of "fitness to satisfy wants." Thus, we have the fitness 
which inheres, so to speak, in the economic object: an elemen- 
tary utility, as for example in the mere substance of copper; 
and a form utility, illustrated when that copper has been 
drawn into wire and prepared for carrying an electric current. 
Besides this inherent fitness, we have the fitness which con- 
sists in the relations of the economic object to men. Thus a 
loaf of bread situated where it is wanted is more useful than an 
exactly simlilar one situated where it is not wanted, and accord- 
ingly the economist talks of place utility; ice which is pre- 
served from the cold months when it is not wanted till the 
warm ones when it is wanted, assumes what we call a time 
utility ; and a commodity passing from the hands of a person 
who has no need of it to those of one who does have such 
need, acquires an ownership utility. 

Again, it should be noted that utility includes all sorts of 
fitness to satisfy wants, without respect to the character of the 
wants. Thus, the fitness of coal to warm one is utility and the 
fitness of bread to nourish one; but the fitness of diamonds 
to give one aesthetic enjoyment or even of whiskey to give 
him vicious enjoyment is also utility — to the economist, dia- 



ANALYSIS OF PRODUCTION 43 

monds and whiskey are just as truly useful as coal or bread. 
This of course does not mean that the economist holds dif- 
ferent ideas from other people as to the relative importance 
of necessaries and luxuries or as to the undesirableness of us- 
ing intoxicants. But in his terminology he must recognize the 
common element in diamonds, whiskey, bread and all other 
economic objects which fits them to satisfy human wants; and 
utility is the word which he has adopted for this purpose. 

Another point to be noted before we leave this general 
topic, the meaning of "produce," is that produce should not 
be understood to mean creating value. Since it is the produc- 
ing of wealth that we are talking about ; and, since wealth has 
value, it might seem that, to produce, one must be responsible 
for the existence of value. But this is a mistake. The pro- 
ducer as such is not responsible for every element in wealth 
but only for the element of utility. His task is to do what- 
ever needs to be done to insure that objects or conditions 
shall be fitted to satisfy man's wants. Now, this must, of 
course, be done before the objects or conditions will have 
value. In doing it, therefore, the producer contributes to the 
process whereby value comes into existence. But he is not 
wholly responsible for the result. The existence of value re- 
quires the fulfilment of two conditions: (i) that the thing 
having value shall be useful and, therefore, wanted, and (2) 
that it shall, for one reason or another, be scarce, — limited in 
amount as compared with what is wanted. The productive 
process fulfills the first of these conditions. But, in so far as 
the fulfilment of the second depends on the productive proc- 
ess, it is the necessity for that process, not its carrying out, 
which does the work. Because we must produce things if 
they are to exist, because our capacity to do this is limited as 
compared to our wants, and probably, also, because production 
involves sacrifices, the amount is certain not to be adequate to 
the satisfying of all our wants. As a result the things produced 
are certain to have value. But this result the producer, per se, 
has not brought about. To the extent of his capacity and incli- 



44 



PRINCIPLES OP ECONOMICS 



nation, he has neutralized one of the conditions, namely, the 
scarcity of the product. And this is his function as a producer. 
His business is to give things the capacity to satisfy wants and 
so the capacity to call forth demand. That these things, after 
all, are scarce and so command a price is due to conditions not 
resulting from the productive act.* Perhaps the most convincing 
argument on this point is that the producer could best contrib- 
ute to the fulfillmg of the scarcity condition of value by acts 
sharply opposed to the productive act, namely, by refraining 
from production or even by actually destroying goods. 

One last point to be remarked under this head. We should 
attribute to each producer the utilities of the particular com- 
modity (or the particular service) for which he is immedi- 
ately responsible. Thus, the farmer produces, not bread or 
flour, but wheat. The miller produces not bread but flour. 
The employes of the miller produce not flour but services, 
which the miller combines with the services of various ma- 
chines and wheat in such a way that he produces flour. 

Section B. Economic Factors of Production 

It is obvious on the least reflection that to produce wealth 
or economic goods necessitates the combined operation of dif- 
ferent things, — dififerent elements, forces, conditions. To raise 
potatoes, for example, we need a place on the land, suitable 
soil, labor, tools, sunlight, moisture, nitrogen from the air, 
and so on. Now, all these different things — these elements, 
forces, conditions, we call factors of production. They in- 
clude everything which contributes to the result attained; and 
their number is legion. But not all of these factors belong to 
our study. A very considerable number of them we call 
non-economic, meaning that they are lacking in the character- 
istics which belong to all things economic. While all of them 
are useful, not to say necessary, to man, they are not appro- 
priable, or are superabundant, or are given gratuitously by the 



* We assume, however, that those conditions are fulfilled. See 
page 41. 



ANALYSIS OF PRODUCTION ' 45 
^„ f^;] ^^ fake on the 



44 



PRINCIPLBS OP ECONOMICS 

INSERT, p. 44 

Illustrative Problems. 

1. The conception of "produce" held by the man who calls middle- 
men parasites is really the same as the one given in the text, though we 
emphatically deny his contention that middlemen are parasites. Defend 
that statement. 

2. "St. Thomas is not a producing island. Its importance consists in 
its position as a harbor of refuge and a coaling station, and as a place for 
refitting vessels." Show from the passage that St. Thomas is a producing 
island, as we understand the word. 

3. Have the playing cards of a gambler utility? Are they wealth? 
Has a diamond ring utility? 

4. A man who is getting no income now but expects to have one six 
months from now borrows $ioo from his neighbor, promising to pay back 
the $100 and $6 more at the end of a year. 

(a) Does the $6 represent any advantage, — service, — received by the 
borrower? 

(b) If so, can the lender reasonably be credited with the production 
of that service? 

5. "Only miners, lumbermen, farmers, and such like ought to be 
called producers ; for they are the only ones who add something to the 
total wealth. The rest merely change the form or relations of the things 
which the above-named produce." 

Show that there is no essential difference in the contributions of the 
farmer, the miller, the baker, the grocer, and the delivery man. 

6. "The Chinaman lives economically. He earns all he possibly can 
and saves it and takes it back to his native land. He is a very economical 
consumer, and instead of being a wealth producer, acts as a leech upon the 
wealth of the nation, sucking in all that he can and taking it away to enrich 
the land of his ancestors." Criticise the part in italics. 

7. Mr. X. hires the opera house for an evening and hires the Mendels- 
sohn Quartette to give a concert in it. I pay 75 cents to hear the concert. 

(a) In precisely what does the wealth which I buy consist, the work 
of the singers, the pleasure I derive from the singing, or something else? 

(b) Did the Quartette produce the wealth I bought, or something 
else? 

(c) If the Quartette did not, who did? 

8. "Thus there are today tens of thousand of lawyers, bankers, trad- 
ers, middlemen, speculators, and others, whose functions, necessary to the 
capitalistic regime, would (under socialism) cease to have any value. They 
would be compelled because of this to enter the producing class." 

(a) Show from the quotation itself that, under a reasonable inter- 
pretation of the phrase "producing class," the groups of persons named are 
already in that class. 

(b) May the labors of these persons be productive now, although 
they would not be productive under socialism. Don't forget to explain. 

9. "Labor alone is the producer of wealth; take away labor and not 
all the capital in the world could produce anything." 

Allowing the second clause to be true as a statement of fact, does it 
prove the proposition contained in the first? 

ID. Accepting the conception of wealth given in these Outlines, the 
conductor of a street car is a producer of wealth. 

(a) Just what form of wealth does he produce? 

(b) For whom does he produce it? 

(c) Who produces the wealth I buy when I ride in the cars? 



ANALYSIS OF PRODUCTION 45 

government, or for some other reason fail to take on the 
property of value, especially pecuniary value, which is the dis- 
tinguishing mark of economic things. Non-economic factors in- 
clude the sunlight, moisture, and nitrogen, mentioned above, al- 
so the body of knowledge inherited from the past by each 
generation, the protection of government necessary to suc- 
cessful production, the many direct contributions of govern- 
ment to productive processes, the gratuitous advice and as- 
sistance of other persons not directly participating in a par- 
ticular task, and many other things one could mention. Many 
of these non-economic factors are absolutely essential and so 
of an importance indefinitely great. But, in general, the econ- 
omist gives them brief consideration because they do not be- 
long to his realm or belong to it only in a very limited sense. 
His study, therefore, is chiefly occupied with those factors of 
production which are strictly economic. 

The distinguishing characteristic of economic factors was 
noted above. Such factors have value, — in the present or- 
der, have exchange value, and that expressed in terms of 
money — pecuniary value. These economic factors are very 
numerous, including the land, the great variety of substances 
out of which or with the help of which man produces 
goods, and many different types of effort or sacrifice which 
man himself must undergo. For some economic purposes, any- 
how, the grouping of these factors into a few large classes 
seems of little utility. Not much is gained, for example, by 
making a study of wages which includes under this head pay- 
ments for the services of ditch diggers, railroad presidents, 
and Carusos. But, while we should all the time bear in mind 
the really great diversity among the economic factors, for 
some purposes it is very desirable to group them into a few 
great classes. The classes commonly recognized by economists 
are the three following: (i) those of natural origin, roughly 
designated by the one word land, (2) those of human origin, 
the efforts and sacrifices that human beings make in produc- 



46 PRINCIPLES OP ECONOMICS 

ing things — usually covered by the term labor, and (3) things 
which have been produced by man and nature but are destined 
to be used for further production, — intermediate products — 
commonly designated capital. We will now make a somewhat 
detailed study of these different types of factors. 

I. Labor 

By labor we mean the effort directly put forth by human 
beings, including not only labor in the popular sense of physi- 
cal exertion, whether skilled or unskilled, but also mental and 
nervous efforts of any sort — ^book-keeping, managing, adver- 
tising, or promoting. It makes no difference how humble the 
effort or how high, it makes no difference whether the effort 
be directly applied to the materials out of which the good is 
being produced, or whether it be applied indirectly, as in the 
management of a concern or in service on the board of di- 
rectors — that effort classifies in the economic sense as labor. 

The specific contribution which labor makes to the exist- 
ence of an economic good consists in a shifting or rearrange- 
ment of the materials that compose it. Labor cannot, strictly 
speaking, perform an act of sheer creation by adding to the 
world's stock of imperishable and unproducible matter the 
substances of which a commodity — say a pair of shoes — is 
made. It can only remove the hide from the cow where it 
grew ; at the tannery, remove from the hide certain undesir- 
able elements and add others more desirable so that the hide 
becomes a strip of leather ; and at the factory, cut the leather 
into pieces, arrange pieces of various sizes and shapes in cer- 
tain relations to each other, and secure them there by the ad- 
dition of other elements, such as nails, thread, and glue. In a 
word, labor creates no substance or substance utilities, but it 
does create in a substance already existing the utilities of 
form, time, place, and so on. 

That the functions thus performed by labor are essential 
to almost every kind of production, is too evident to need ar- 



ANALYSIS OP PRODUCTION 



47 



gument. Labor is, therefore, a factor in production, — a physi- 
cal or technical factor. But it is no less certain that labor is 
also a true economic factor. It cannot be had for the asking ; 
it is scarce relatively to the need for it ; it has exchange value. 

2. Land 

The second element. Land, includes in general all the con- 
tributions made by nature ; meaning both land in the popular 
sense, as position on the earth's surface, and various sub- 
stances, such as coal, iron, water, and standing timber in the 
forest, which exist as they are without any care or interven- 
tion of man's. 

The specific contributions which Land makes to the exist- 
ence of economic products will be apprehended at a glance. It 
furnishes place, the ground on which man himself and all as- 
sisting factors are located ; and the original substances out of 
which all goods are produced, — the primary raw materials. 
In view of these facts, it is manifest that there is no form of 
production which does not require the participation, in some 
kind or degree, of this element or factor. Land or Nature is a 
necessary factor in all production. 

But, though land or nature is a factor in production, is it 
necessarily an economic factor? If we mean to include every- 
thing from nature which man employs in production, the an- 
swer is obviously in the negative. Air, moisture, and sun- 
light, while necessary to production as physical or technical 
factors, are not controllable or appropriable, and therefore 
lack the element of value, — for which reason, they have no 
standing whatever as economic factors. Again, position on the 
earth's surface, though appropriable, may fail of being count- 
ed as a true economic factor. In partially settled countries 
some of the land actually in use is no more desirable than 
much which is not in use; there are other waste pieces lying 
all about which could be substituted for the used piece with no 
decrease in the product, and at practically no expense. Now, 



48 PRINCIPLES OP ECONOMICS 

because other land of its kind is so abundant, the particular 
piece first occupied will have no price. It will be a free good, 
like air or moisture, and, so, according to our definition of 
economics, will not be an economic factor. 

But, after all, comparatively few of nature's contributions 
can be disposed of in this way. While position on the earth 
is free in the wilderness, it is in settled communities very dis- 
tinctly not free, because, in proportion to the population, it 
has become scarce. Commonly, then, land, as position on the 
earth's surface,— the original, unproducible, indestructible 
earth — is a true economic factor. No argument is needed to 
show that the same is often true of Primary Raw Materials, 
such as coal and iron in the earth and standing timber in the 
forest ; these also usually have value because relatively scarce, 
and so must be accounted economic factors. 

Some might, perhaps, object to the argument that land 
necessarily comes to have value and so comes to be an eco- 
nomic factor, in this wise. "All land was originally a free 
good, a gift of nature. That it now has value and, so, is an 
economic factor in the sense here used, is due to unjust laws 
which authorize private persons to own it, — make it their 
property." The unsoundness of this view is easily shown. 
Ownership is essential to the existence of exchange value ; but 
such value cannot be given by ownership alone ; there must be 
scarcity as well. If there is monopolistic ownership, to be 
sure, this scarcity itself may be secured artificially, and so the 
economic character which the scarcity helps give to the land 
will be in so far arbitrary in nature. But the ownership of 
land is not usually monopolistic; there are many competing 
owners. The scarcity of land, taken generally, is a perfectly 
natural thing; the available supply is limited just because the 
earth stands as it was created; and hence the value of land, 
arising from scarcity, is also perfectly natural. Even under 
socialism, land would have a natural value because of its nat- 
ural scarcity, and for that reason would be an economic fac- 
tor, just as truly as now; only, the owner of the land would 



ANALYSIS OP PRODUCTION 



49 



then be the state, and accordingly the contribution made by the 
land in production would be credited to the state rather than, 
as now, to private individuals. We must conclude, therefore, 
that, wherever land is scarce relatively to need, it should be 
counted as one of the true economic factors of production. 

3. Capital 

Capital, the third principal factor in production, gives us 
one of the most difficult topics in our science. While this is, 
in part, to be charged to the failure of economic specialists 
to reach complete agreement in respect to the proper analysis, 
it is largely due to the inherent difficulties of the subject. In 
this connection, therefore, we have to ask for more than ordi- 
nary care and patience on the student's part. 

Capital, as commonly understood by economists, particu- 
larly in connection with the topic of production, means pro- 
duced goods which are intended to assist in further produc- 
tion. Such goods contrast with the second factor in produc- 
tion, land, in that they are produced, not given by nature. On 
the other hand, they contrast with consumer's goods, or con- 
sumption goods, in that they are destined to be employed, not 
to satisfy wants directly, but to help in producing something 
which will satisfy wants. Thus, a factory building, with 
the steam or water power created for it, and the tools and ma- 
chinery of various sorts set up within it, are clearly goods 
which we would never produce for purposes of immediate 
enjoyment, but only for the purpose of further production 
which will result in shoes, clothing, and other commodities. 
Likewise the leather and the wool or cotton yarn which go 
into these factories gratify human wants only indirectly, by 
virtue of the fact that they are on the way to become shoes 
and clothing. 

The fact that the kind of goods which the above definition 
puts under the designation capital have as one distinguishing 
mark their use in further production has led to various other 



50 PRINCIPLBS OP ECONOMICS 

designations for those goods. Thus, they are sometimes named 
"producers' goods," and sometimes "intermediate prod- 
ucts." The method of production which pursues the poHcy 
of using such intermediate products instead of trying to pro- 
duce the consumption goods directly, is known as the round- 
about method or "the capitahstic method." 

Now, if we confine our thought strictly to the concept of 
capital as defined above, there can be no occasion for answer- 
ing the questions discussed in connection with labor and land, 
namely, whether we have here an actual factor and whether it 
is really an economic factor. The tool, the engine, the ma- 
chine, are obviously producing in the sense that we can get 
more product with them than without them, hence they are 
factors. Further, they have a price, and so are economic fac- 
tors. 

But, if by a strict interpretation of our definition of capi- 
tal we simplify our task in one direction, we immediately in- 
crease its difficulties in another. For, if capital is nothing 
more than produced goods devoted to further production, the 
question at once arises whether capital as thus defined is really 
an independent factor, a factor different from the labor and 
land which have already been treated. Capital goods, inter- 
mediate goods, the objector declares, being themselves prod- 
ucts, are mere embodiments of previous elements or factors. 
The hoe with which I cultivate potatoes is, of course, some- 
thing different from the labor which uses it. But, while now 
different, the hoe owes its origin to the labor which made it, 
and whatever it is able to produce should be credited to that 
labor, just as much as if it had been spent directly on the pota- 
toes. The proper course, then, is to credit the potatoes to la- 
bor solely, — 'though of course to the whole labor involved : the 
labor spent on the hoe and the labor spent in using the hoe.* 



* Since the hoe would be used for many other products, the la- 
bor spent in making it would be credited with its share in other prod- 
ucts as well. 



ANALYSIS OF PRODUCTION 



51 



And, consistently with this procedure, we should describe 
capital as one special kind of labor, "congealed labor," or, if 
we must recognize land as a necessary economic factor, we 
should describe our capital as congealed land and labor. Any- 
how, we cannot properly treat it as an independent factor, 
something really different from nature and labor. 

The answer of the economist to the contention of the last 
paragraph is, in general, this : the intermediate goods under 
consideration must be treated as constituting, in some measure 
at least, an independent factor, because they necessarily em- 
body another element beside labor services and land services, 
namely, the element of time or waiting. Consider the case 
of a fisherman who, instead of catching fish directly with his 
hands, begins by making a net and then uses his net to catch 
them. We do not adequately describe the situation when we 
say that, in making and using the net, he is merely ivorking on 
a different plan from what he would be in catching fish with 
his bare hands. Such language suggests that any one who can 
take fish by the hand method, and who has at the same time 
the technical ability to make and use a net, will be able to ful- 
fil all the requisites of fishing by the net method. But this 
assumption is of course far removed from the truth. The fish- 
erman who has enough dried fish in store so that he can de- 
vote, say, thirty days to the construction of a net, will be able 
to resort to the net method. In contrast, another fisherman 
with equal skill in net making and net using, but who has noth- 
ing to satisfy his hunger beyond today, — he will, just because 
he lacks that surplus of food, be forced to content himself 
with the hand method. 

That this must be so is readily seen. It is a peculiarity of 
the capitalistic method that the producer reaches his goal by a 
roundabout path. Instead of trying directly to accomplish his 
object, he has first to do several other things — things which 
seem perhaps very little related to his ultimate object, but 
which are after all aimed toward the object in the strictest 



52 



PRINCIPLES OP ECONOMICS 



sense. Instead of trying to cut down the tree at once, the 
woodsman first sets about obtaining an axe with which the 
work may be done. But that is a very simple illustration of 
roundaboutness. In a highly specialized economic society, the 
woodsman does not himself even make directly the axe with 
which the tree is to be cut. Far away, perhaps, in some other 
part of the country, iron ore is dug from the mine ; coal is 
mined also and turned into coke ; the coke and the ore are 
used together in turning out pig iron; the pig iron is trans- 
formed into steel, and the steel is fashioned into an axe which 
the woodsman buys finally to cut his tree. Looking at society 
as a whole, the cutting of the tree is the last in a long series 
of processes having no immediate or perceptible connection 
with tree cutting but yet, as it turns out, really directed there- 
to. Roundaboutness therefore, whether simple or complex, is 
an unfailing characteristic of the capitalistic method. 

Now a roundabout method, it is plain, usually if not al- 
ways consumes more time than a direct method. For the pro- 
duction of a certain definite amount, of course — assuming it to 
be a large one — the roundabout method will not necessarily 
prove to be the longer ; on the contrary, it will probably in the 
end prove to have been much the shorter. Thus, if a fisher- 
man wishes to catch a ton of fish, he can do it more quickly 
by first weaving a net and digging out a canoe. On the other 
hand, if the fisherman wants a single meal of fish or meals for 
a day, he surely can obtain that amount by the hand method 
in a much shorter time than it would take him to prepare the 
elaborate apparatus and then catch them. In a word, reckon- 
ing from the time when the first steps toward the goal are tak- 
en to the time when some returns, however small, are received, 
the roundabout method is always the longer. Between the 
incurring of the labor sacrifices necessary for production and 
the enjoyment of the fruit of those sacrifices stretches a long 
interval — hours or days, perhaps even months. Capitalistic 
methods are, in short, time-consuming methods. 



ANALYSIS OF PRODUCTION 



53 



Hence it follows that the resort to these methods usually 
requires of producers something which not every one is able 
to do, namely, to zvait. In other words, no one can hope to 
use the roundabout method of production, the method of first 
creating intermediate goods and then using these to reach his 
goal, unless he has the power, not merely to labor in the or- 
dinary sense, but also the power to wait. If some one wishes 
to regard this waiting as only a special phase of labor, he has 
a perfect right to do so. But, at all events, this element is es- 
sential to the use in production of the intermediate-goods 
method — the capitalistic method — ; and it is an element which 
in practice can he, and commonly is, separated from the ele- 
ment which is unmistakeably a labor element. Accordingly, 
it is necessary to insist that the intermediate goods now under 
consideration are embodiments, congelations, not only of land 
services and labor services, hut also of waiting services. They, 
therefore, have to be distinguished as constituting, in some 
sense and degree, a factor independent of land and labor. 

The preceding analysis has brought us to the point of 
recognizing as a vital element in the concept of capital that it 
should embody time. In fact we have really admitted to the 
objector that he is, in a measure, right; if capital required for 
its production nothing more than land and labor in the ordi- 
nary sense, it would not be sound analysis to treat capital as 
an independent factor. Such treatment is justified only be- 
cause there is necessary in the case another element : waiting. 
But this admission almost compels us to distinguish capital 
as mere products from "capital as capital," — meaning the 
goods in question looked at in just one narrozv way, namely, 
as embodying the power to wait. This is, of course, an ab- 
straction; it can have no existence independent of the goods 
themselves ; but it is an abstraction which need trouble no one 
to carry safely. It is constantly recognized in the process 
whereby the machine has a price representing its costs of pro- 
duction, while the lending of the cash necessary to buy the 
machine has another price, namely, interest. I still hesitate 



54 PRINCIPLES OP ECONOMICS 

to say that the real capital is the fund of value embodied in 
the goods ; but I shall feel at liberty to talk about "capital as 
capital ;" and I shall mean the goods viewed in this narrow 
way, as embodying the power to wait. 

But, now, in presenting this new aspect of capital, we 
have revived the questions which were formerly thrown out : 
namely, whether capital is really a factor at all and 
whether, if so, it is an economic factor. For the capital we 
were then discussing was a narrower concept than that now 
before us. Again, however, these questions need not long 
delay us. In bringing out the new way of conceiving capital, 
we have already shown that the power to wait is commonly 
essential to the use of the capitalistic method. But this being 
true, it follows that capital as waiting-power, capital as cap- 
ital, is necessary to most production. It is, therefore, a real 
factor in production. 

Again, the question whether capital in this special sense is 
really an economic factor is easily settled. As already brought 
out, anything which is a factor in production at all is also an 
economic factor if, as respects^ itself or its services, it shows 
the distinguishing mark of economic things, economic goods, 
that is, value, price. This, as we have seen, is certainly true 
of capital as capital ; its services command a price, which we 
know as interest. Capital as capital, therefore, — capital as 
distinct from the mere product in which it is embodied — is 
not only a factor, but also an economic factor. 

Before leaving the topic of capital, it seems desirable to 
call attention to some distinctions between different forms of 
capital which have more or less currency. I have already ex- 
plained the distinction of capital as capital which I find it very 
convenient to make. That designation means capita] looked 
at as involving waiting. 

A somewhat different solution of the difficulty which we 
met by this concept of capital as capital makes the essence of 
capital to reside in the fund of value embodied in the goods 
commonly called capital. This is real capital, pure capital, 



ANALYSIS OF PRODUCTION 55 

value capital. In contrast, the goods are concrete capital or 
goods capital or capital goods. 

Closely allied to the last distinction is one which contrasts 
money capital with real or goods capital. The former is 
the fund of money which is accumulated and then used to pur- 
chase the goods capital ; or, better, perhaps, which is conceived 
as having been put into the goods capital. This in turn sug- 
gests the distinction of invested capital and free capital, a dis- 
tinction which the terms sufficiently explain. 

A distinction which is sometimes useful is that between 
formal or money capital and real or goods capital. The former 
is the fund of money or bank credit which the capitalist accu- 
mulates ; while the latter consists of the actual goods, the en- 
gines, machines, coal, etc., which are elsewhere produced to be 
bought with the money capital. This distinction emphasizes 
the point that the things which we are really trying to get are 
the engines, machines, etc., the fund of money being only a 
go-between. The distinction must not, however, be taken too 
seriously. In a very important sense, the man who accumu- 
lates the mere fund of money is responsible for the existence 
of the engines, etc. He it is who supplies the waiting-power 
which makes possible this particular employment of our pro- 
ductive resources. 

Among older ways of distinguishing different forms of 
capital is one which contrasts fixed and circulating capital. 
The former is capital, like a tool or a machine, which gives off 
more than one service, while the latter is capital, such as the 
raw material used in making a wooden box or the coal burned 
in a steam engine, which does its part in a single use, gives 
off but one service. An interesting contrast is often drawn 
between specialised and general capital. Specialized capital is 
the kind which is fitted for one purpose only or for a very few 
purposes at most, for example, a planer, a copper steamer, or 
a printing press. Generalized capital on the other hand is 
something like coal, or pig iron, or most of all, money, which 
can be put to any one of many uses. 



56 PRINCIPLBS OF ECONOMICS 

Most people broaden the concept of capital as "products 
devoted to further production," making capital synonymous 
with income-getting goods, or all goods which serve their 
owner indirectly by supplying him with other goods. If we 
take the word in this sense, it is necessary to recognize a dis- 
tinction between social capital and private or acquisitive capi- 
tal. Social capital, which is virtually the same as that discussed 
in the foregoing paragraphs, produces other products, and 
is therefore income-giving even from the social point of view. 
But private, or acquisitive capital — for example, a gasoline 
launch rented to a summer resorter — does not increase the 
total volume of goods and so is not income bearing from the 
social standpoint; it yields an income to its owner only. 

Some writers include under the term capital all durable 
products, not only those devoted to production, but those, 
such as a dwelling house occupied by its owner, which are 
devoted to consumption as well. While the older usage is 
preferred by most authorities, there is doubtless something to 
be said in favor of the new ; and we may find it convenient 
on occasion to speak of producers' capital, meaning the kind 
originally defined, and consumers' capital, meaning consuni- 
ers' goods which have a durable character and give off many 
services. 

A very natural extension of the term capital makes it to 
include such facilities and constructions as highways, canals^ 
and bridges, which are usually maintained by the government. 
These things manifestly show the characteristics of being pro- 
duced and devoted to further production. They are not, how- 
ever, subject to private ownership, and so do not have a price; 
hence they are not wealth in the usual sense, and, if capital 
is to be restricted to wealth in that sense these things are not 
capital. A natural compromise is to call them public capital. 

A less legitimate broadening of our term takes in the body 
of knowledge handed down from generation to generation 
which plays a very large part in economic production. In a 



ANALYSIS OF PRODUCTION 57 

sense, this has been and is being produced ; and it is obviously- 
being used to assist production. It is not, however, included 
among the things which possess exchange value, command a 
price. It is not, therefore, wealth ; and, not being wealth, it 
can be called capital only in a figurative way. It is some- 
times designated social or public capital. 

Finally, it is sometimes convenient to speak of personal 
capital, in reference to the bodily or mental capacities and ap- 
titudes of human beings. Most economists, however, consider 
such language figurative. Capital is only a particular kind of 
wealth, or wealth looked at in a particular way. But personal 
capacities are not wealth because, not being transferable, they 
have no exchange value ; and if they are not wealth, they can- 
not be called capital in the economic sense of the term. 

4. Responsibility-Taking 

We have thus far recognized only three classes of factors 
the operation of which conditions the existence of practically 
any and every economic product. With these three, econo- 
mists usually stop. But there has emerged more or less clear- 
ly an implicit recognition of a fourth factor*, namely, as- 
suming the responsibility of production — willing that 
production shall go on. That this is an essential condition 
is obvious. Failure to isolate it in setting forth the different 
factors is, perhaps, due to the fact that under simple indus- 
trial conditions it is too intimately associated with one or more 
of the other factors. That the farmei who uses his land, la- 
bor, and capital to raise wheat must mill to raise wheat is too 
evident to need comment, — indeed, it is involved in saying 
that he so uses them. Is it not, then, a mere fantastic refine- 
ment of theory to separate this function in the total process 
from the rest? The reason for a negative answer is not far to 
seek. The plain fact is that, instead of being a refinement of 



* It seldom appears explicitly in discussing the factors of produc- 
tion. 



58 PRINCIPLES OP ECONOMICS 

the theorist, a more or less complete separation of the respon- 
sibility-taking function from the other functions is character- 
istic of actual industrial practice. The men who are respon- 
sible for the producing of the vast majority of goods and 
services outside agricultural products, rarely own the land 
which they use, perform little or no labor themselves, and own 
only a part, anyhow, of the capital employed in the business. 
This would seem to establish pretty conclusively the claim of 
this function to be a separate one in the productive process, — 
to be a fourth factor in production. 

It may, however, be objected that, granting what has been 
said, this plainly distinguishable function, after all, belongs to 
one of the factors already discussed, namely, capital. If the 
man who assumes the responsibility of willing that produc- 
tion shall go on does not himself supply the capital, he must, 
anyhow, have other property to insure the capitalists from 
whom he borrows ; since otherwise, not he but they would 
really be assuming the responsibility. This objection is suffi- 
ciently true to make it best, perhaps, to treat the function un- 
der consideration as one of two capitalistic functions, — making 
those two waiting and responsibility-taking. To do so does 
not seem quite logical, since, in the case of the producer who 
borrows the capital he employs and secures his loan by a claim 
on other property, the waiting-power — the capital — actually 
employed is supplied by some one else. The responsibility-tak- 
ing function, one might say, belongs to property rather than 
capital. However, the point is not important. The function 
is very real and, in both theory and practice, easily distin- 
guishable from the one which we have recognized as pecu- 
liarly the capitalistic function, namely, waiting, supplying the 
condition essential to the use of time-consuming methods. We 
shall, therefore, recognize it as a fourth factor in production 
without further eflfort to define its precise relation to capital 
in the narrower sense. 

The function of responsibility-taking involves making the 
general decision to produce in the field chosen, the bearing of 



ANALYSIS OF PRODUCTION 59 



INSERT, p. 59 



Illustrative Problems. 



1. "Discovery and invention have doubtless played a very large part 
in securing our present high industrial efficiency. But they are not the 
whole thing. The increase of capital has been equally necessary; for, 
without capital, invention could have accomplished little or nothing." 
Defend and illustrate the last sentence. 

2. "The common pursuit of forestry as a private business almost had 
to wait until capital became relatively very abundant." Why should this 
be true of forestry more than of wheat raising? 

3. The following is taken from a short story in a recent number of one 
of the popular magazines. The hero inherited great wealth in rolling mills 
and has for several years successfully continued the business. He is also 
public-spirited and liberal. Referring to his charities, the author says : 
"What was it that he had given? Something that he . . . had never 
earned. His hands had never touched belt or pulley. He looked at them 
curiously. It was the toil-hardened hands of twelve hundred other men 
that made his giving possible — the hands of the men he was planning to 
turn off on Monday." 

Show that, if this was a normal case, we could impute to the services 
of the twelve hundred workmen only a part of the net output of the mills ; 
that the portion going to the proprietor was reasonably enough credited to 
his contribution to the business. Enumerate several elements which 
probably entered into his contribution. 

4. "The most of us live by our wits — spend our time wheedling the 
true producers, the men who work with their hands, into sharing with us 
the things which they produce." 

Give several illustrations of kinds of labor necessary to production 
which would not naturally be described as working with one's hands. 

5. Josiah Wright, the wagon maker, is making a lumber wagon which 
he expects to sell to some neighboring farmer. Now, a wagon is un- 
doubtedly capital or capital goods ; yet in making that wagon, Wright is 
not strictly speaking, producing capital. Explain the riddle. 

6. Some writers have been disposed to affirm that, in the last analysis, 
all capital gets its start in a surplus of the means of subsistence, particu- 
larly food. This undoubtedly has considerable force as applied to primitive 
conditions. Illustrate the proposition for a community of fishermen. 



^8 PRINCIPLES OF ECONOMICS 



tl 
si 
is 

si 

S( 

v\ 
o 

t: 
t 






ANALYSIS OF PRODUCTION 



59 



anxiety, the assumption of various kinds of risk, and a limited 
amount of managing, so much as is incapable of delegation 
to persons working for hire. Such a function is plainly the 
most vital and central in the whole productive process. Na- 
ture provides material; labor provides power to rearrange the 
material ; capital provides waiting-power, enabling these ma- 
terials to be arranged by a round-about process ; yet, though 
all these were present, no product could come into existence 
without the willing that the required rearrangement of mate- 
rial should take place. The will-to-produce is the produc- 
tive factor par excellence. All other factors contributing to 
a business are naturally conceived as auxiliary to this ; their 
services are assembled and combined through the will-to- 
produce; and out of the will-to-produce emerges directly that 
commodity which is the product of the business taken as a 
whole. 

Assuming the responsibility of production is, therefore, a 
factor in production, — something without which production 
cannot go on. But it is also an economic factor; for it com- 
mands a price. The men who perform this service must, gen- 
erally speaking, receive a profit in return for their services. 

Accordingly, we shall usually speak of four classes of fac- 
tors in production: Land (nature), Labor, Waiting, and Re- 
sponsibility-taking. Three of these are manifestly of hu- 
man origin. We may, therefore, group the four as follows : 

i Nature — Land 
Factors •^ ( Labor 

' Man } Waiting 

( Responsibility-Taking 

Section C. The Agents (Actors) in Production 

The preceding discussion has dealt with the factors em- 
ployed in productive processes, the factors formally set apart 
and distinguished as by a chemical analysis. Now the con- 
trol of these several factors is in the hands of human beings. 



6o PRINCIPLES OF ECONOMICS 

and is, or at least may be, in the hands of different classes of 
human beings. Accordingly, we are able to name several 
classes of producers, of human agents or actors in produc- 
tion, corresponding to the different factors. This classifica- 
tion has already been anticipated ; but a more explicit refer- 
ence is now demanded. 

1. The agent in production corresponding to the first fac- 
tor is, of course, the laborer, — the human individual who fur- 
nishes services which are the product of his own effort. It 
makes no difference whether the services are of physical or 
intellectual character; it makes no difference whether they 
are of the humblest sort, or of the greatest and most conspic- 
uous, the man who furnishes them is a laborer. Promoting is 
labor, and managing is labor, as we have seen; and the pro- 
moter and the manager are therefore laborers; the $100,000 
president of a corporation is a laborer as truly as his office 
boy or the mason building his walls or the machinist in his 
shops. 

2. Just as the laborer is the human agent in production 
corresponding to the element or factor called labor, so the 
agent corresponding to the factor called land is the land owner 
or landlord. The landlord is the individual who furnishes for 
productive purposes the use of land or land services. It is 
possible, as we conceded in the preceding section, to have an 
economic order in which land owning is not permitted, and 
therefore one in which this agent of production is not repre- 
sented by any private individual. But it is not now possible, 
nor has it been possible since the very beginning of society 
to have an order in which there was not some sort of land- 
lord present as an agent in production. At the first moment 
any part of the existing land comes to be wanted by more 
than one person, at that moment it acquires value, and takes 
on the character of an economic good. Some one then inevi- 
tably appropriates it in order to reap the advantage of its su- 
perior desirableness ; this some one may be an individual per- 



ANALYSIS OF PRODUCTION 6i 

son or the community as a whole ; but, whether one or the 
other, we will certainly have to secure his participation be- 
fore we can utilize the land as a factor in production. Such 
was the course of events in early societies, and such will al- 
ways be their course. Undoubtedly we can if we like substi- 
tute public for private landlords; but, private or public, the 
landlord is a necessary agent in production, and we can never 
get rid of him. 

In saying that a landlord is present in every productive act, 
we do not of course mean to imply that he always exists as 
a distinct person. The land factor, as we have pointed out, is a 
different thing in its nature and in its contribution from the la- 
bor factor. But this is not to say that the land and labor cannot 
be controlled simultaneously by the same person. On the con- 
trary, it is very common for the laborer to furnish his own land 
and for the landlord to perform his own labor — a perfect exam- 
ple being that of a farmer or gardener who tills the soil he him- 
self owns. Nevertheless, in admitting the presence of the two 
agents in the same person, we by no means reduce the two 
agents to one. To the extent that a man labors, he is a la- 
borer, just as if he owned not a foot of land; and, for all the 
land he furnishes, he is a landlord, just as if he performed no 
labor whatever. 

3. The third agent in production is the capitalist, the in- 
dividual who furnishes intermediate goods or its equivalent 
in money funds to be used in carrying on a business. The 
capitalist does not labor; he does not furnish land; neither 
does he take any responsibility for making the business go, nor 
place in risk the principal of his capital or the payment for 
its use. The capitalist simply waits, or furnishes waiting- 
power which makes possible the institution of roundabout 
methods of production. The use of "capitalist" in this defi- 
nition is highly technical, and subject in some degree to the 
charge of arbitrariness. But it is no more so than the best of 
the others which we might adopt ; and hence, for its practical 



62 PRINCIPLBS OP ECONOMICS 

utility in the further analysis of our subject, we shall regard it 
as correct. 

The capitalist may, to be sure, exist in the same person 
as the landlord and the laborer. Men who own buildings and 
machinery very frequently own the land upon which they op- 
erate, and also, as laborers, attend to the operation of these in- 
termediate goods. The farmer is the most obvious of many 
examples of a man who is capitalist, landlord, and laborer in 
one. 

But, while we recognize the possibility of a common res- 
idence for the different agents, the emphasis, especially as re- 
gards the capitalist and the laborer, should perhaps be placed 
on a contrary tendency. In a state of primitive industry, la- 
borers almost universally own their tools, and men who own 
tools are also the wielders of them. But modern conditions of 
production tend more and more to separate the two agents. 
The amount of capital required for a modern business under- 
taking is very great, thousands of dollars often being invested 
in a machine which a single laborer can operate. The ordi- 
nary laborer cannot by any effort of saving accumulate so 
much capital as this, and accordingly the saving is and must 
be done by other people who perhaps perform little labor in 
the ordinary sense. And even when laborers do save some- 
thing from their incomes, the accumulations seldom make 
them masters of the particular tools they use. Their money is 
deposited in a bank, and, by a process to which we shall give 
more attention later on, establishes them as part capitalists in 
concerns other than those where they are employed, and usu- 
ally in concerns of which they have no knowledge. 

But, even if there were no such tendency as the one just 
described, even if the three agents existed usually in the same 
individual, this fact would not, in our logical analysis, reduce 
the three agents to one. In so far as a man labors he is a 
laborer ; in so far as he furnishes land, he is a landlord ; in so 
far as he furnishes waiting power, he is a capitalist. 



ANALYSIS OF PRODUCTION 63 

4. The primary, central factor in production is respon- 
sibility-taking; hence the primary, central agent in produc- 
tion is the person, natural or legal, who supplies this factor. 
Adam Smith (1776) called this person the undertaker, a des- 
ignation now out of vogue. Recently some writers have tak- 
en to using a newly-coined term, enterpriser. But most writ- 
ers using the English language nowadays employ the French 
equivalent of Adam Smith's term, the word "Entrepreneur." 

The Bntrepreneur is the agent who assumes responsibility 
in productive undertakings. If our analysis of economic fac- 
tors has been understood, little further exposition will be re- 
quired at this point. The entrepreneur is not a laborer but an 
employer of labor; he is not a landlord, but a renter of land; 
he is not a capitalist, but a borrower of capital. He rents from 
the landlord, borrows from the capitalist, and hires a body of 
laborers ; and, marshaling together the elements obtained from 
these, he institutes production. 

It should be remarked, however, that the division of func- 
tions cannot be so precise in the case of the entrepreneur as 
in that of any other agent. Even as entrepreneur, he cannot 
divest himself of functions which, from their nature, seem to 
belong to labor or capital. It is true that most of the labor 
furnished by some entrepreneurs could usually be performed 
quite as well by laborers they could hire. In respect to labor of 
this sort, therefore, the entrepreneur is merely a laborer. But 
certain duties he can escape only by ceasing to be an entrepre- 
neur, for example, appointing the higher director or mana- 
gers of the business, and making certain final decisions with 
respect to the conduct of the business. These acts constitute 
labor as we ordinarily understand it, the putting forth of per- 
sonal effort. Yet the entrepreneur does not therefore classi- 
fy as a laborer; for these acts cannot be performed by a true 
laborer, but are inseparable from his functioning as entrepre- 
neur; in performing them he is not less, but rather more, of 
an entrepreneur. A similar complication arises in the furnish- 
ing of capital. An entrepreneur may and usually does put 



64 PRINCIPLES OP ECONOMICS 

some of his own capital into a business. With respect to that 
capital, he may be thought of as both capitalist and entrepre- 
neur. By means of it, he is in part furnishing the service of 
waiting necessary to the conduct of the business. He, there- 
fore, credits to himself interest on this capital just as he 
would pay it to a lender. But the same capital serves in part 
as the basis of his power to perform his distinctive office as 
entrepreneur, that is, assuming the responsibility and risk of 
production. He, therefore, expects the entrepreneur's re- 
muneration on this capital, in addition to the interest he re- 
ceives on it as a mere capitalist. In other words, in respect 
to that portion of the capital which he himself supplies, he is 
both capitalist and entrepreneur, and gets pay for both types 
of service.* 

It is sometimes necessary to distinguish different kinds of 
entrepreneurs, namely, the individual and the collective entre- 
preneur. The term individual entrepreneur, as an entrepre- 
neur existing in a single person, sufficiently defines itself. The 
collective entrepreneur may exist in any one of the legal busi- 
ness entities such as the Partnership, the Joint Stock Com- 
pany, or the Corporation. 

In the case of industries undertaken by corporations, the 
corporation as such, the collective unit, is from the stand- 
point of formal logic the true entrepreneur. But cautious in- 
terpretation is here necessary. The corporation, acting through 
its usual organs, the president, secretary, and general mana- 
ger, cannot be the entrepreneur, because these organs are cre- 
ated by a more fundamental power, the board of directors. 
Again, the corporation acting through the board of directors 
cannot be the real entrepreneur, because that body is created 

* In this analysis, if the entrepreneur gets fifteen per cent, on the 
investment, five or six of this must be reckoned as interest, only the 
remainder as true profits. In practical business, it is more usual to 
think of the whole fifteen per cent, as profits, though most business 
men would at once admit the theoretic propriety of dividing that fif- 
teen per cent, into different parts : true interest, true profits, and, usu- 
ally, wages. 



ANALYSIS OP PRODUCTION 65 

by a power still more fundamental, the general meeting of 
stockholders. When at last we reach the general body of 
stockholders, acting in the way prescribed by their charter for 
the decision of vital questions, we are in the presence of some- 
thing which may fairly be called ultimate, — there is nothing 
behind to determine its action. This general body of stock- 
holders, therefore, should probably be recognized as the true 
claimant for the title and functions of entrepreneur. In some 
respects, on the other hand, the stockholders as a mere aggre- 
gate of individuals seem best to deserve the title ; particularly 
at the starting of a corporate undertaking, the question of 
whether or not the industry shall be carried on at all — the 
taking of ultimate responsibility for production — rests with 
investors as individuals, not with the body of stockholders 
formally organized. Accordingly, for some purposes we have 
to locate the entrepreneur of a corporation in the stockholders 
formally organized, while for other purposes we must recog- 
nize this agent in the mere aggregate of stockholders. 

Finally, we must say of the entrepreneur what we have 
said of all the other agents, that he does not necessarily exist 
apart as a separate individual, natural or legal. Illustrations 
will at once occur of men who are entrepreneur, capitalist, 
landlord, and laborer all in one. In fact, there probably never 
is in the real world any such complete separation and special- 
ization of the different agents as might be suggested by the 
foregoing analysis. But, in any case, the point already much 
emphasized must be remembered, that, even where all agents 
exist in a single person, they are logically distinct, because their 
functions are distinct. As a laborer, the man labors ; as a 
landlord, he furnishes land ; as a capitalist he furnishes wait- 
ing-power; and as an entrepreneur he furnishes responsibility- 
taking, an element which includes a small residuum of labor 
and waiting. 

To conclude this discussion let us repeat what has before 
been clearly hinted at, regarding the relation of the different 
agents. The co-operation of all the agents is required in prac- 



66 PRINCIPLES OF ECONOMICS 

tically all productive undertakings ; and, since there are no 
degrees in necessity, it would be incorrect to say that one is 
more necessary than the others. Nevertheless, the last agent 
discussed, the entrepreneur, does stand in a peculiarly signifi- 
cant relation to all the others and to the product. In a sense, 
he merely employs the other agents as his auxiliaries, and he 
is responsible for the product. Hence, in the ordinary way of 
thinking, we esteem him as more important than the other 
agents. In recognition of this judgment we shall call the en- 
trepreneur the producer par excellence, and where "produc- 
er" is used in the later pages of this volume without qualifi- 
cation, it will be an entrepreneur whom we have in mind. 



66 PRINCIPLES OP ECONOMICS 



INSERT, p. 66 



Illustrative Problems, 



1. "In co-operative production (meaning production in w^hich the 
w^orkmen own the business) the place of the entrepreneur is taken by a 
manager elected by the workmen." — Text-book. Criticise. How is the 
entrepreneur constituted in co-operative production? 

2. "Today, all over the land, masons, hod carriers, carpenters, and so 
on, are building palaces which other people are to live in. When socialism 
triumphs, all this will be changed. The worker, no longer robbed of the 
fruits of his labor, will himself occupy the palaces he builds, wear the 
broadcloth he makes, and eat the choice viands he produces." 

(a) Does justice require that the worker should have the right to con- 
sume the particular object he expends effort on? Explain. 

(b) If it did, would the particular set of workers — masons, hod 
carriers, carpenters, and so on — who construct the palace have the ex- 
clusive right to enjoy it? Explain. 

(c) Show that other persons besides "workers" in the sense here 
used have supplied conditions necessary to the existence of the palace. 

3. Until recently it was usual to teach that the peculiar function of the 
entrepreneur is to manage, direct, industry. One feature of modern in- 
dustrial organization almost compels us to reject this idea. Explain. 

4. "Postponing consumption so that production may be carried on in 
a roundabout way is the function of the capitalist." — Text-book. Explain 
and illustrate. 

5. Why do we say that ever}' stockholder of a corporation is an ele- 
ment in the corporate entrepreneur while a bondholder, who also has 
capital in the concern, is not? 

6. Not many years ago Mr. W, after some months of painstaking 
negotiations, induced a number of persons owning certaia lands on the 
Copper Range to join with him in organizing a corporation to build a rail- 
road, open, mines, etc., — Mr. W putting in some land of his own. For his 
fee, Mr. W was to receive a certain number of shares in the stock of the 
company. 

Distinguish with explanations the two economic roles played by Mr. W 
in this matter. 



CHAPTER V 

GENERAL CONDITIONS OF PRODUCTIVE 
EFFICIENCY 

Production, as we have seen in the preceding chapter, is 
accompHshed by the united action of several different factors. 
Productive efficiency, the subject of the present chapter, means 
a condition or state of economic production in which the em- 
ployment of a given quantity of these different factors results 
in a relatively large or desirable product. 

That a high degree of efficiency should be maintained is, 
of course, directly to the interest of the entrepreneur in charge 
of any industrial enterprise. But it is also to the interest of 
every person in the community. By the very first principle, 
formulated in Chapter II, every person (or community) in a 
co-operative order such as ours, tends to gain from any in- 
crease in the economic efficiency of other persons or commu- 
nities with which economic relations are maintained; and, di- 
rectly or indirectly, every person in our system maintains such 
relations with every other person. Doubtless the extent to 
which individuals profit personally from such efficiency is sub- 
ject to great variation; but we can scarcely conceive of any 
one so situated that he would not gain something. It becomes 
pertinent therefore to make some inquiry into the laws and 
principles under which production may attain, and remain in, 
a state of high efficiency. 

At the outset of this inquiryj however, it should be noted 
that Economics does not attempt an exhaustive investigation 
into the technical conditions of productive efficiency. In its 
study of agriculture, for example, it does not concern itself 
directly with f ertiHzation, drainage, and rotation ; nor, in its 
study of manufacturing, does it touch upon power genera- 
tion, the choice and placing of machinery, and the like. These 



68 PRINCIPLES OF ECONOMICS 

problems lie rather within the special province of the techni- 
cal arts themselves; they are problems of agriculture and man- 
ufacturing, not of Economics. The field of Economics lies 
deeper. It embraces the more general principles which under- 
lie and govern the purely technical phenomena of all the arts 
alike. Let us begin with a broad survey of these princifftes, 
and continue with a more particular examination of some of 
them in their relation to the different economic factors. 

I. Capitalistic Methods 

One clearly established principle is that industries can us- 
ually increase their productive efficiency by the introduction of 
methods which employ a large amount of capital. Methods 
using some capital are probably without exception better than 
methods using none; and, as a rule, methods using much are 
better than those using little. 

In our day practically all production is capitalistic. There 
are to be sure marked differences in the degree to which capi- 
talism is carried in various industries. Some industries, from 
their very nature, seem able to use more capital than others 
located in the same city or country ; and the industries in one 
city or country may, in general, use more than those in an- 
other. But, however great these variations, the fact remains 
that most industries can use all the capital available, and the 
more they use the higher is the productive efficiency to which 
they attain. 

The principal explanation of this increase in efficiency was 
brought out on page 51. Through the roundabout method, 
men are able to reinforce their own powers with the powers 
of nature, and thus to rearrange the materials upon which 
they work with relatively greater speed and precision. In the 
beginnings of industry, when the primitive fisherman, for ex- 
ample, made a net and a boat to use in catching fish instead 
of depending on his naked hands alone, the gain in efficiency 
was enormous; and even in later stages of industrial develop- 



PRODUCTIVE EFFICIENCY 69 

merit some invention like the steam engine, the dynamo, or the 
cotton gin gives to our productive efficiency an increase start- 
lingly great. These facts would seem to be so familiar as to 
need little comment. Still they are not infrequently over- 
looked in times of popular excitement ; and legislative meas- 
ures are adopted and enforced which discourage the accumu- 
lation of capital or drive it out of the community. It was 
needful, therefore, that the point should receive some empha- 
sis. 

2. Specialization 

We saw in Chapter II that the present economic order is 
one of heterogeneous co-operation, wherein each person spe- 
cializes ; and that each individual in the system finds this spe- 
cialization advantageous because it enables him to enjoy more 
goods and a greater variety of goods, and goods of better 
quality than he possibly could if he attempted to produce ev- 
erything for himself. Now, of course, the primary reason why 
specialization enables the consumer to consume more and bet- 
ter goods is that it enables the producer to produce more and 
better goods. We have thus already clearly implied that spe- 
cialization is one chief source of productive efficiency. Let 
us now consider this point a moment from the producer's 
standpoint as we formerly did from the consumer's. 

In the first place, specialization utilizes all agents and in- 
struments of production, even the inferior ones. It splits up 
our complex industrial processes, dividing the small tasks 
from the great ; so that a person who cannot perform a whole 
process, because he is incapable of doing the difficult part of 
it, may nevertheless contribute something to the whole because 
he is capable of doing the easy part. Thus a boy who would 
be quite helpless as the manager, machinist, or salesman of a 
concern, may make himself very useful running errands. On 
the other hand, specialization utilizes superior instruments and 
agents most fully. A steam locomotive designed for pulling 
forty or fifty loaded freight cars across the country at thirty 



70 PRINCIPLES OF ECONOMICS 

miles an hour is kept constantly moving in that service, while 
lighter trains in the terminal are handled by locomotives of 
smaller power; a skilful surgeon need not trifle away his time 
at mowing the lawn or going to the newspaper office for his 
paper — he can abandon those tasks to inferior agents and de- 
vote all his skill to dangerous operations in the hospital. 

Specialization utilizes natural aptitudes, especially in the 
land and labor factors. A man endowed with a mechanical 
genius is kept busy at mechanics, instead of being required to 
cultivate corn; and land that will raise fifty bushels of wheat 
to the acre is reserved for that valuable product instead of 
being given up in part to forestry or grazing. Specialization 
also permits the development, in the labor and capital factors, 
of artificial aptitudes. A pianist can greatly improve the flex- 
ibiHty of his hands, and consequently his skill as a player, from 
the fact that he is permitted to refrain from heavy manual 
labor and spend long hours at finger exercises on the key- 
board. About the only implement the primitive man pos- 
sessed was the knotted stick, and he could use it to destroy 
his enemies, to grind his corn, to pillow his head at night, and 
for numberless other purposes. But, viewed from the mod- 
em standpoint, the implement was not well adapted to any 
of those purposes ; and specialization has given us thousands 
of different implements, creating in each a special aptitude 
for one kind of work. Again, specialization economizes in 
time for men and machines, since it eliminates the loss, often 
very large in the aggregate, of changing from one task to an- 
other. It also shortens the period of apprenticeship or edu- 
cation: a man can learn to be a skilful mason more quickly 
than he can learn to be both a mason and a carpenter. Finally, 
specialization stimulates invention — a man devoting himself 
completely to one particular job and learning all the niceties 
of it will find more ways of improving his performance than 
a man working now here, now there, on a dozen different 
jobs. 



PRODUCTIVE BPFICIBNCY yi 

We have just seen that specialization contributes greatly 
to productive efficiency. It follows that the full realization of 
any condition requisite to such specialization must contribute 
to productive efficiency. Now, as pointed out at the very be- 
ginning of our study, one such condition is exchange; under 
the present system, specialization and the co-operation it in- 
volves is made possible chiefly through exchange. That is, in 
order to take advantage of the principle that specialization in- 
creases efficiency, we must exchange products with one an- 
other. It follows that the degree to which this specializing 
can be carried depends on the extent of our exchanging. If 
we trade with only a few people, the need for a single kind of 
goods will be too small to justify any one of us in producing 
that kind only. Thus, the man who calls himself a barber in 
a small town can do most of the barbering which his neigh- 
bors require at night and on Saturday afternoon ; and the rest 
of the time he must fill in as he can mending shoes, soldering 
tin pans, or lending a hand on odd jobs at the garage. He 
cannot specialize in barbering, or in any one of his other trades, 
because the amount of service wanted by the community with 
which he exchanges is not large enough to keep him busy. 
Hence we have the following : 

Principle. The extent to which productive efficiency can 
be increased by means of specialisation varies directly as the 
extent of the market. 

The foregoing principle suggests one of the chief reasons 
why economists as a class are free traders. They favor the 
utmost possible freedom from restrictions because this allows 
the largest amount of co-operation and thereby enables every- 
one to benefit most completely by the productive activity of 
every one else. All economists, of course, would admit that 
free trade in some commodities is more important than in oth- 
ers, just because trade of any sort in some commodities is 
more important than in others. An import duty on hay would 



72 PRINCIPLES OF ECONOMICS 

for some years not affect us one way or another — it would be 
a mere futility, since we do not normally buy much hay out- 
side our country. Any departure from freedom in steel goods, 
textiles, and sugar, on the contrary, is sure to have notable 
results, because we would naturally import those things in 
large amounts. But, whether we deal in a commodity much 
or little, the privilege of trading without restrictions when we 
see an advantage will conduce to the productive efficiency of 
all the countries concerned. Hence the following corollary. 
Corollary. High productive efficiency depends on a large 
amount of freedom of trade. 

Ii^i^usTRATivE Proble;ms 

1. In most economic text books, one meets the phrase 
"geographical division of labor." 

(a) What do you suppose it means? 

(b) Give some illustrations of it. 

2. Give some examples of recently developed labor spe- 
cialization, — if possible from your own observation. 

3. Same as Problem 2 for capital. 

4. Why is it that a country store keeps a little of every- 
thing, while a city store very often deals in only one kind of 
commodity, e. g., shoes or china or sporting goods. 

5. It is sometimes said that nowadays almost everything 
is produced for a world market. 

(a) What is one of the greatest gains of having such a 
market ? 

(b) What are some of the most important industrial 
changes which have made it possible ? 

(c) Suggest one or two of the most serious evils which 
would naturally result from it. 

2. Large Scale Production 

It is a fact familiar to all of us that the extraordinary in- 
dustrial progress of the last hundred years, and particularly 
of the last twenty-five years, has been accompanied by a great 



PRODUCTIVE EPPICIBNCY 



73 



expansion in the scale on which industry is conducted. On 
the one side, the total output of commodities has greatly in- 
creased, their quality has, in general, been improved, and their 
price lowered — so that today men who are considered poor 
may enjoy comforts which a hundred years ago would have 
been envied by kings. On the other side, we find that the es- 
tabHshments which produce these commodities are not so nu- 
merous as they were twenty-five or fifty years ago, but that 
the individual establishments now producing are in size, as 
compared to the old ones, very much larger. These two phe- 
nomena, it is generally recognized, have been in some measure 
related as effect and cause; our industrial progress has partly 
resulted from the enlarged scale of the producing operations. 
The big store, the big factory, the big railroad has been able 
to supply its particular product in greater volume, at much 
smaller cost, and often of much better quality. Large scale 
production has meant more efficient production. 

Among the principal reasons for the superiority of large 
scale production are the following : 

(i) Large scale production permits a great extension of 
the policy of specialization. That this policy greatly increas- 
es productive efificiency has already been brought out. The 
particular form of specialization which comes into our present 
topic is that which manifests itself within a single industrial 
establishment. In such an establishment, when the scale of 
production is sufficiently large, each man or each machine may 
take only some very small step in the total process. In a 
great automobile factory where thousands of cars are con- 
structed every day, it is feasible to install a machine for 
stamping out a single, very small standardized part of the 
car, because the number required is so great that the ma- 
chine can work steadily all day, and probably all night at that 
one unvarying task; whereas, in a small factory such a ma- 
chine could be kept running only a few hours per day and so, 
owing to the expense of installation and upkeep, its use would 



74 PRINCIPLES OP ECONOMICS 

not be feasible. That large scale production makes possible 
this extreme application of the policy of specialization is thus 
one great reason why it increases productive efficiency. 

(2) A second important reason for the connection be- 
tween large scale operations and productive efficiency is the 
fact that large scale production secures economy in the use of 
different factors or instruments. Two phases of this principle 
should be noticed, (a) At certain points specialization has 
to be carried almost as far in the small concern as in the large 
one ; and the large one permits a f idler utilisation of the spe- 
cialized factor. Thus the country store at Four Corners is 
obliged to employ at least one clerk, although in the long in- 
tervals between customers he spends three-fourths of his 
time whittling the nail keg ; in a city department store in con- 
trast, most clerks are continuously busy waiting on custom- 
ers. A railroad company producing transportation between 
New York and Boston is obliged to lay and maintain at least 
one hne of track even if, owing to the competition of other 
lines, it runs only two trains a day; but if the road conducts 
a large business, the same single line of track can at a very 
slight increase of expense be utilized by dozens of trains. 

(b) A second manifestation of the economy of large scale 
production is to be found in the fact that, while each produc- 
ing concern has to keep in its stock of raw materials, tools, 
and finished products some reserves to meet contingencies, the 
reserves of a large concern are sure to be relatively much less 
extensive than those of the small concern. If there are four 
haberdasher stores in a town with an adult male population of 
one thousand, each store will need in the spring a stock of 
straw hats perhaps 50 or 100 in excess of its probable sales. A 
single large store, replacing the small ones, and with probable 
sales as great as all of them together, would need contingency 
reserves but little greater than any one of the four. 

(3) Again, large scale production makes it possible to 
utilize waste products. A familiar illustration is that of the 



PRODUCTIVE EFFICIENCY 



75 



great packing houses where various portions of the slaugh- 
tered animals which, taken in small quantities would be worth- 
less, accumulate to such an extent that the total has consider- 
able value, and can be used with profit. Where cotton is 
ginned at a small plant, the seed extracted from the fiber is 
thrown away or destroyed ; but large ginning concerns develop 
from the seed important by-products, oil and meal. The total 
amount of such economies effected by large industries is enor- 
mous, though a small plant, in attempting to utilize similar 
waste, would spend more than it would save. 

(4) Finally, large scale production insures better bar- 
gains when a concern comes on the market as a buyer or sell- 
er. A large concern can buy its supplies more cheaply than 
a small one, because the seller, under competition, is willing 
to accept a relatively small profit in order to close the large 
transaction; or, more important, he can often sell goods in 
large quantities at a smaller rate without lowering the profit, 
because the expenses connected with the large sale — the sell- 
ing effort, the clerical work, the packing, the transportation — 
are relatively lower than those connected with the small sale. 
In selling its product, on the other hand, the large concern has 
corresponding advantages over the small. Just because it pro- 
duces more efficiently, it can sell at a lower price and yet ob- 
tain quite as high a profit. And, by means of its superior sell- 
ing force — its salesmen, its advertising, its show rooms and so 
on — it can usually outsell small concerns at the same level of 
prices. 

As a qualification upon all the comments made above, it 
should be noted that industrial units have an indefinite, but 
none the less real, Hmit to the size at which they can be ef- 
fectively worked. The limit is high in some industries, like 
manufacturing, because the restricted area covered by manu- 
facturing operations makes supervision of the workmen easy. 
It is low in other industries, such as agriculture, for the oppo- 
site reason. The organization unit, the unit having a single 



76 PRINCIPLES OF ECONOMICS 

managerial, clerical, and buying and selling force can, it often 
seems, be enlarged indefinitely; but it is in fact limited by the 
organizing abilities of business men in the time and country 
where the unit seeks to operate — a concern may become so 
large that the securing of honest and efficient management is 
well nigh impossible. The physical unit of production, the 
plant, will of course reach a size beyond which it cannot prof- 
itably be increased much earlier than the organization unit. 

4. Integration of Industries 

In the preceding sections we have discussed the condi- 
tions of productive efficiency with regard to which there is 
much confirmatory experience and little difference of opinion. 
In this and the following section, we meet two alleged meth- 
ods of increasing efficiency which are of more recent origin 
and, in many minds, of doubtful value. One of these meth- 
ods, which has been named the integration of industries, con- 
sists in bringing together under one control many industries 
which, though dissimilar, are interdependent. Thus the steel 
producer does not confine himself to the single process of con- 
verting pig iron into steel. He undertakes also to maintain 
a plant for making pig iron from the ore, and another one for 
getting the ore from the mine ; he may in addition own and 
operate coal mines and coke furnaces to obtain the fuel he 
needs; and may construct railways to transfer his various 
completed or partly completed products from one plant to an- 
other. 

One reason why this integration promotes efficiency is that 
it enables the producer to realize more fully the gains natural 
to large scale production. Another reason is that it secures 
a variety of economies, due to the complemental nature of the 
industries integrated, particularly in that each of these indus- 
tries, save the lowest, provides a market for the product of 
some other member of the series, and thus saves the expenses 
of selling and diminishes the risk burden. The production of 



PRODUCTIVE EFFICIENCY 



77 



steel, which furnished the first great application of this meth- 
od has been and still is eminently successful ; and numerous 
other industries have in late years adopted a similar practice 
with favorable results. 

5. Unification of Industries 

A very characteristic development of industry during the 
last twenty years, particularly in the United States, is the 
coalescing of many hitherto independent industrial units of 
the same kind into a single all-inclusive unit. Such units are 
commonly known as trusts or combines. The practice illus- 
trated in their organization is contrasted with that just de- 
scribed under Integration, in that the latter combines dissimi- 
lar, though interdependent, units, while trusts combine simi- 
lar units. An integration puts together coal mining, iron 
mining, pig iron making, and steel making. A trust puts to- 
gether the American Steel Company, the Carnegie Steel Com- 
pany, and the IlHnois Steel Company. 

Evidently the formation of a trust must in most cases real- 
ize one of the conditions already considered, largeness of scale 
in production, and hence it must so far tend to increase pro- 
ductive efficiency. Thus, a combination bank which takes the 
place of five independent banks, will be five times as large as 
the average of the five, and its efficiency will be much greater 
than five times the average. 

But, secondly, the combination unit will naturally have 
some advantages not necessarily belonging to an original unit 
of equal size, derived from the very fact that it is the result of 
combination, — that it has grown out of a variety of sources. 
For different ones of the combining units may have developed 
specially efficient methods or machines which, hitherto kept as 
trade secrets, will be much more fully utilized under the com- 
bination. In an equally large unit which was a single unit 
from the outset, many of these methods would perhaps never 
have been developed. 



78 PRINCIPLES OF ECONOMICS 

A third possible ground for expecting greater productive 
efficiency from the trust or combination is to be found in the 
fact that such a combination secures partial or complete mo- 
nopoly in the industry involved. This condition is without 
doubt very objectionable on a variety of grounds. But we are 
here concerned only with its relation to efficiency; and, while 
there is room for controversy even on this side of the matter^ 
the consensus of informed opinion would seem to be favorable 
to the claims of the trust.* The chief ground on which great- 
er efficiency is claimed for monopoly is that it makes possible a 
number of economies vv^hich are not possible under free com- 
petition. 

(i) A big firm with no competition can diminish its ad- 
vertising, reduce its force of salesmen, and, in general, cut 
down all the expenses of marketing its product. This is equiv- 
alent to saying that the firm can produce its goods — ^f rom raw 
material to consumption stage — with less efifort and at less 
cost, and therefore clearly means a gain in efficiency. (2) The 
monopoly can have plants in all parts of the country, and fill 
orders from the particular plant nearest the consumer, thus 
minimizing the costs of transportation. (3) The monopolist 
need not seek to adjust production to his possible share of a 
considerable demand, — a quantity very difficult even to ap- 
proximate — he can adjust it to the whole demand, a quantity 
which can often be ascertained quite exactly. He thus incurs 
less risk from loss, and in so far as that risk is a cost of pro- 
duction he is enabled to produce more efficiently. 

It should be evident from all the above discussion that 
combination, whether it results in monopoly or not, belongs, 
on many important grounds, among the conditions with which 
this chapter is concerned. We are therefore probably justi- 



* Perhaps the best proof of this is the tendency of all the great 
industrial nations to favor the formation of trusts (syndicates, cartels) 
as necessary to the maintenance of their position in the competition for 
the trade of the world. 



PRODUCTlvn EFFICIENCY 79 

fied in saying that, generally speaking, mere technical efficien- 
cy is usually increased by the consolidating of like industries 
under one control. 

IlIvUSTRATIVE PrOBIvKMS 

1. Some of the big farms of East Prussia have their own 
little railways, locomotives, cars, etc. What advantage of large 
scale production does that illustrate? 

2. Suppose that the five banks of Ann Arbor were to be 
united into one and that, while each of the uniting banks em- 
ploys a cashier, a teller, a book-keeper, and a messenger, the 
consolidated bank were to employ a cashier, a paying-teller, 
a receiving teller, a discount-clerk, a collection-clerk, a head 
book-keeper, an assistant book-keeper, and a messenger. Show 
that the facts as stated illustrate two gains of large scale in- 
dustry. 

3. "If the four or five dry-goods stores on Main street 
were united, a great saving in the fund of circulating capital 
required in that business would be effected." 

(a) Argue for the truth of the quotation. 

(b) Show that the new plan would probably effect a sav- 
ing in fixed capital also. 

6. Industrial Freedom 

The last quarter of the eighteenth century found most of 
the western nations dominated by governments which exer- 
cised a very complete despotism not only in respect to matters 
commonly regarded as well within the scope of political ac- 
tion, but also in respect to economic matters. The trade or 
occupation which each individual might enter was prescribed 
from his birth ; the period to be spent in apprenticeship, learn- 
ing the trade, was likewise already arranged ; and, when he 
became a qualified workman, the amount and kind of goods he 
might produce and the remuneration he might receive for it 
were not determined by his will or choice, but by the law. 
Manufacturing industries also were regulated in the minutest 



8o PRINCIPLES OF ECONOMICS 

way; the kind of materials each estabhshment should use, the 
amount of materials it should devote to each unit of product — 
for example the number of threads in a square yard of cloth, 
— and the quantity of product it might finish in a given time, 
were rigidly fixed. And, to insure observance of the laws, in- 
spectors were always on hand who exacted penalties with the 
greatest severity. 

In its beginning this excessive interference with the spon- 
taneous course of industry was probably justified; it had the 
negative effect at least of preventing labor and labor's output 
from falHng below a certain standard. But there early devel- 
oped among business men and thoughtful students a distrust 
of such interference. It was not only annoying, they thought, 
and inconsistent with principles of personal right and liberty, 
but it actually hindered the attainment of the result at which 
it was aimed. Nations intended to make themselves efficient 
and rich, but by the very means employed for this end they 
destroyed their efficiency and so became poor. For various 
reasons, near the close of the eighteenth century or in the 
early years of the nineteenth, the latter notion came to be 
widely accepted and incorporated into government policy. As 
a result of this change, or as a result of it in combination with 
other forces, industry thereafter advanced at a quite unpar- 
alleled pace. Hence modem economists have come generally 
to hold the opinion that, whatever objections there may be to 
it on other grounds, industrial freedom undoubtedly contrib- 
utes to efficiency. 

Freedom of trade we have already discussed from this 
view point. It widens the market for each individual's goods, 
and thereby encourages that thorough-going specialisation 
which contributes so greatly to industrial efficiency. The free- 
dom of individuals to choose their own occupation and to 
produce according to self-set and market-set standards, has 
advantages no less important. In the first place, it tends to 
give industrial forces a direction which will naturally result in 



PRODUCTIVE EFFICIENCY 8i 

the greatest productivity. ( i ) As a rule, the individual him- 
self is better able than any one else to decide what he is fitted 
to do, or at any rate what he can do with keenest interest and 
a good will ; hence in occupations freely chosen, both aptitude 
and interest will guide him in the production of more and bet- 
ter goods. (2) By producing the things for which he is best 
fitted, a man confers the greatest number of utilities upon so- 
ciety at large, for whom the things are produced. But, con- 
versely, when society comes to obtain these things by exchange 
from the producer, it also confers the greatest number of 
utilities upon him. Hence, if a man is free to choose, he will 
have not only the motive of workmanship pleasure, but also 
that of economic gain, for turning his energies into the most 
efficiently productive channel. 

Second, and no less important, is the fact that under a 
regime of freedom men are spurred on by the stimulus of 
competition or emulation. That a man has the privilege of 
making any product for which he discovers an aptitude, and 
of selling the product so widely as to gain a great profit if 
he can make it well enough, — ^that he may hope, on the one 
hand, to gain almost anything if he works efficiently, and that 
he is in danger, on the other hand, of losing to others almost 
everything if he does not so work, — these are conditions which 
call forth the most strenuous efforts of most men. Finally, 
there are certain moral qualities generally recognized as requi- 
site to good workmanship — self-reliance, decision of charac- 
ter, energy, industry, and so on — which are naturally best de- 
veloped under conditions where the individual acts on his own 
initiative, not like an automaton under the guidance of an 
outside power. 

It must be admitted, of course, that the general truth here 
set forth has, like most others, numerous limitations. Advo- 
cates of non-interference have always recognized that some 
governmental oversight of industry is necessary to secure the 
very liberty which they wish to see prevail, since one individ- 



82 PRINCIPLES OF ECONOMICS 

ual may become so strong and so ruthless in the use of his 
strength that he will restrict the liberty of other individuals. 
On this ground, governmental action has in our day been ex- 
tended very far — in the control of monopolistic combinations, 
for example — and that with the approval of most economic 
thinkers. Further, experience under the laissez faire regime 
has shown that the industrial efficiency secured by some forms 
of freedom may be purchased at too high a price. Excessive 
labor of women and children, physical injuries from improp- 
erly guarded machinery, and kindred evils, have called for and 
secured much remedial legislation. At the present time, there 
still remain many abuses incident to great industrial liberty 
the correction of which is perhaps more important than the 
high efficiency to be derived from that liberty. It is probable 
therefore that for some time we shall see not less, but more, 
governmental interference along these lines. 

In addition to these purely restrictive forms of interfer- 
ence, there are others of a more positive nature which a gov- 
ernment may sometimes engage in with results undoubtedly 
beneficial to industry. By its grant of franchises, a govern- 
ment encourages the building of railroads, thereby giving to 
industry all the benefits of easy transportation — especially a 
wide market — and its dredging of harbors and digging of 
canals contribute toward the same end. In a new field of ac- 
tivity where there seems to be a lack of private initiative, the 
government has investigated industrial methods and offered 
itself, more or less informally, as an instructor. The agricul- 
tural experiment stations is an illustration, and the free bulle- 
tins and weather reports supplied to farmers. There has de- 
veloped also in very recent years a strong movement for voca- 
tional direction, which aims, not to determine people's occu- 
pations for them by authority, but, by expert study of per- 
sonal aptitudes and of accessible occupations, to help the indi- 
vidual choose the work in which he will be most successful. In 
all these lines, also, it is probable that the future will bring 



PRODUCTIVE BFFICIBNCY 83 

rather an increase than a diminution of governmental activity. 
Admitting all these limitations, however, the statement that 
non-interference contributes to efficiency still holds good. The 
needed control, on the one hand, and the patronage or instruc- 
tion, on the other, should be kept at a minimum, and should be 
carried out with care and discretion. In general, industrial ef- 
ficiency is greater under a regime of freedom, non-interfer- 
ence, laissez faire, than under one of much governmental reg- 
ulation. 



CHAPTER VI 

EFFICIENCY OF DIFFERENT FACTORS 

The preceding discussion has set forth the more general 
principles of productive efficiency. It still seems desirable to 
take up separately the different factors concerned in produc- 
tion, and ask how efficiency is best secured in connection with 
each of them. Let us begin as we have in earlier analyses with 
the labor factor. 

Section A. The Efficiency of Labor 
If the particular contribution of labor to productive proc- 
esses is the power or force to arrange nature's materials, then 
labor will be efficient which arranges those materials relatively 
well. It remains to inquire what characteristics will enable 
labor best to exert its force, and how those characteristics may 
be secured. 

The first essential of the labor factor is mere physical 
strength and endurance, the ability to put forth a relatively 
large amount of force at any one moment, and to continue 
such exertion for an extended period of time. The sources of 
such strength are fairly well known. They are in part racial, 
evidently, since the workmen of one race average much high- 
er in bulk and brawn and physical power than those of an- 
other race ; they are in part matters of a narrower family in- 
heritance, since, of two workmen of the same blood strain, 
one may exhibit capacities greatly in excess of the other. But 
with these causes we are not particularly concerned in the 
study of economics. What we are concerned with is the fact 
that of two men of equal natural endowment, one may supply 
much the greater force ; and, the reasons of this can generally 
be found in the superiority of the food he eats, of the house 
he occupies, and the generally sanitary and helpful conditions. 



EFFICIENCY OF FACTORS 85 

under which he lives. From this it is but one more step to the 
final answer of our question. How do men come by the mate- 
rial goods necessary to enable them to lead the kind of life 
most conductive to physical fitness? 

Our present economic order being one of exchange coop- 
eration, most goods are obtained through exchange from 
others. But, in such an order, the amount of goods each man 
gets will be affected by the amount of goods he himself pro- 
duces and offers in trade, and, on the other hand by the 
amount produced in the group with which he exchanges. 
Hence, the limitation of the goods that can be enjoyed by each 
man is set by the productive efficiency of the group. Men's real 
incomes, and consequently their physical strength may, then, 
be said to depend on an observance of the general laws of pro- 
ductive efficiency set forth in the last chapter — capitalistic,, 
large-scale, laisses-faire production and all the rest. That this 
should be true, from a priori considerations is easy to see. But 
it could also be shown by a study of industrial history and so- 
ciology that the living conditions, and so the physical fitness of 
workmen has uniformly been far superior in those countries 
where these laws of productive efficiency have been observed 
than in countries where they have not. 

A second characteristic of the labor factor is mental pow- 
er. Mental power is important first as the director and the 
source of skill for mere physical strength; if one does noth- 
ing but pick up sticks it is better that he pick them up in an in- 
telligent and clever manner. The need for skilled craftsman- 
ship seems smaller in our day than it formerly was, because 
the man who once made a complete object with his own hands, 
tends now to be replaced by the man who makes only a very 
small part, and that by means of machinery. Nevertheless, the 
skill that was once needed for the direction of one's hands is 
now the more needed for the care and tending of the compli- 
cated and delicate machines. But there is a further use for 
mental strength in the labor factor. In our analysis of pro- 



86 PRINCIPLES OP ECONOMICS 

duction we defined labor not as physical force only, but as 
any and all kinds of exertion, including the higher intellectual 
forms. Exertion of the mind is itself labor. In our present 
system of large scale, highly capitalized production, the pure- 
ly intellectual exertion of the promoter, the manager, and oth- 
er agents is the most important labor of all. And so, for such 
labor, there is special need in the laborer of unusual mental 
power. 

Disregarding natural gifts, men acquire mental power 
chiefly through the processes of training or education. The 
first prerequisite of such acquisition is the desire of the indi- 
vidual; and it often seems that where this desire is strongly 
present it will carry one over all obstacles to the goal. Of 
this point we shall speak further in a moment. But for the 
masses of mankind, something else is needed, a something of 
more concern in economic studies, because it can be provid- 
ed by economic means. Perhaps the clearest economic source 
of mental fitness will prove on examination to be identical 
with that of physical fitness — productive efificiency. For most 
of us it is necessary first, that training facilities be provided, 
free and accessible, if not compulsory, and that, second, the 
immediate problem of sustaining life should not press upon us 
too hardly, but leave us leisure and strength for self -improve- 
ment. But, clearly, these two requisites will be most fully 
met in a state of high productive efficiency. A country effi- 
cient in production will be a wealthy country; and, other 
things being equal, a wealthy country will have more abun- 
dant means of education, with more opportunity for their 
enjoyment by its citizens, young and old. 

A third characteristic essential to the effectiveness of la- 
bor may be broadly named as willingness or ambition. How- 
ever great men's natural endowment of body and mind, and 
however excellent their opportunities for development, labor 
will always be ineffective if it lacks in the quality of willing- 
ness. 



EFFICIENCY OF FACTORS 87 

The willingness to work depends primarily, no doubt, on a 
general attitude of mind which makes the possession of eco- 
nomic goods, the sensation of much-having, an experience 
worthy to be striven for. Occasional rare individuals with a 
taste for simplicity prefer to unburden themselves, as they 
conceive it, of all material things except the bare necessities of 
life; and, if in addition they are preoccupied with some ideal- 
istic pursuit, they will naturally show little inclination to per- 
form economic labor. Likewise certain oriental peoples and 
religious sects regard serenity of mind and contemplation as 
more to be desired than any amount of material wealth. 
Among western peoples, however, a natural taste for economic 
goods seems all but universal. So far as willingness to work de- 
pends on a desire for the fruits of work, they are willing 
enough. 

The next requisite for willingness or ambition is the avail- 
ability of goods worth buying. A frontier settler, or a peas- 
ant in the interior of China, however keen his craving for en- 
joyable goods, will not greatly exert himself, he will raise only 
what he can consume and will in general tend to become a 
shiftless no-account, unless the products of more civilized 
communities are within buying distance. But the only stim- 
ulus needed for these peoples is productive efficiency in their 
neighbors, and improvement in the means of transportation 
and exchange. Thus certain Eastern countries have even in 
this generation become keen, active producers, mainly because 
Western nations brought to their doors commodities which 
they wanted, but which they could not have unless they pro- 
duced, for exchange, something wanted by the Western na- 
tions. 

Given a natural taste for material goods, and a stimula- 
tion of that taste by the presence of such goods, there is still 
often something wanting to induce willingness to work. That 
something is an assurance that, having worked, one will be 
allowed to consume a quantity of goods proportionate to the 



88 PRINCIPLES OP ECONOMICS 

effort put forth. In other words there must, ordinarily, be' 
some guarantee of the reward. . Now, in the existing economic 
order, the amount of a man's reward is for the most part de- 
termined automatically, by the process known as distribu- 
tion. Whether his reward, as so determined, is proportion- 
ate to the effort put forth, may therefore much better be re- 
served for a later part of our study. In some part, however, 
the assurance of one's reward has its source quite outside the 
realm of Economics proper. It springs from a general confi- 
dence in the moral integrity of the community where one lives 
and with which one maintains business relations. One must 
know that his neighbors are not going to steal his goods, 
whether restrained by their sense of right or by the policing 
activities of government. One must know that the govern- 
ment itself will not confiscate his property or drain him dry 
by exorbitant taxes, and that the government is able to defend 
him from invasion and robbery by foreign foes. 

Section B. The Efficiency of Land 

The land factor in production furnishes man with posi- 
tion on the earth's surface, with primary raw materials, and 
with natural powers. The question of land-effectiveness in 
its simplest form is merely, "how can nature supply man with 
most materials of the best sort?" So far as nature's own part 
is concerned, the question is easily answered — she can supply 
most by being rich, fertile, plentiful. But nature is passive, 
what she supplies is supplied once for all, or in a blind and 
purposeless way, so her "activities," if such may be called her 
mere existence, is hardly a matter for discussion. But from 
man's viewpoint there is much to be said. How can man 
realize the greatest amount of utilities from the existing nat- 
ural supply? 

Any given individual can do best for himself with na- 
ture's materials if he is free to command all he wants at any 
time he wants them. Nature's materials are most efficient for 



EFFICIENCY OF FACTORS 89 

me if I can, whenever the need arises, go out and cut down 
timber, dig ore, or plant grain on any selected piece of ground. 
But the viewpoint of particular individuals is not important 
here. Considered absolutely, land is most efficient when it is 
available for that man, among all men, who is qualified to de- 
rive from it the greatest product. There are several ways in 
which this fortunate availability might be secured. For ex- 
ample, a communistic form of government might parcel out 
various portions of the existing supply to individuals adjudged 
most competent. Another possible method is for free com- 
petition to determine who can produce most from each por- 
tion and then for a system of private ownership to reserve for 
that individual the exclusive use of the portion, free from the 
interference of others. The latter method is the one gener- 
ally prevailing at present ; it results in a high degree of land- 
efifiiciency, and as such will doubtless be preserved until one 
unmistakably better is found. 

A system of free competition, private ownership and ex- 
clusive use can, however, be modified somewhat, and the land- 
efficiency thereby be enhanced. The condition of free avail- 
ability for the most competent needs definition. Under some 
circumstances, land is most efficient if it yields all its mate- 
rials at once and is thenceforth exhausted. A forest is most 
efficient for the pioneer and for all who will follow him, if 
he utterly destroys a large part of it to use for fences and 
firewood, and puts the denuded land under cultivation in small 
grain. But, generally, it is best that the large trees only be 
taken from a forest, while the younger ones are left to finish 
their growth, and to sow the seed of still other trees to follow 
them. In other words, nature will make the greatest contribu- 
tion to productive processes in the long run under a policy of 
conservation. She will be most efficient through the years if 
she yields at no one time enough to diminish her future yield. 
But men, working under conditions of private ownership can- 
not always be trusted to persevere in such a policy. Where in- 



90 PRINCIPLES OF ECONOMICS 

dividual wisdom and self-restraint are insufficient, therefore, 
the interference of government to advise, and even to enforce, 
conservation will contribute greatly to the productive efficiency 
of land. 

Section C. The Efficiency of Capital 

A very little reflection will make clear that efficiency on 
the side of capital is conditioned chiefly by three things : an 
abundant stock, availability, and wise employment. The last 
of these depends mostly on the skill and capacity of the en- 
trepreneur who determines what shall be produced, and so de- 
termines to what use capital shall be put. Accordingly, we 
are here concerned principally with the conditions which in- 
sure an abundant stock of capital, and which insure that the 
existing stock shall possess a high degree of availability. 

I. An Abundant Stock of Capital 

In dealing with the abundance of capital, the first problem 
which meets us concerns the origin of capital. By what proc- 
esses does it come into existence? The answer to this has al- 
ready been anticipated, but a special reminder in the present 
connection will be useful. 

A piece of capital goods, if viewed simply as a physical 
object, has to be brought into existence in exactly the same 
way as consumption products, that is, through consciously 
directed labor assisted by land and capital. Just as certain 
factories are engaged in making hats, golf balls, candy, and 
other consumption goods, so certain factories are engaged in 
making engines, machines, tools, and other capital goods. At 
first sight, then, it might seem as if such a factory were the 
place to study the question "How does capital come into exist- 
ence?" In fact, however, we are here interested in something 
deeper than mere technical production. We are looking for the 
ultimate origin of capital, the moral origin, so to speak. This is a 
legitimate question to ask with reference to any product ; for, 



EFFICIENCY OF FACTORS 91 

under an exchanging economic order, the technical producer of 
anything, whether it be an engine or a pound of candy, is 
not, in the most ultimate sense, responsible for its existence. 
He produces that engine or candy because he knows or ex- 
pects that other people will buy it from him. He is in effect, 
therefore, acting as the agent of those people. This is evi- 
dent enough in production to order; but production for a gen- 
eral market is not essentially different, for it is possible only 
because experience has shown that it will work substantially 
the same as if production were to order. 

Accordingly, if we wish to know the ultimate origin of 
capital, we must go to the principal rather than to the agent. 
The ownership of engines or other capital goods means the 
tying up of large amounts of value so that for an extended 
period they will yield income — service — to the owner only at 
intervals and in small amounts. Not everyone, therefore, can 
afford to buy and own such goods. How does the actual buy- 
er of capital goods attain his ability to buy? In case the buy- 
er is an entrepreneur merely, he largely borrows money to 
make the purchase, so that a further inquiry is necessary. How 
does the man who lends money to the borrowing entrepreneur 
reach a position where he can give up, say, $3,000 in cash in 
exchange for a yearly income of $150? The answer is plain. 
He must have accumulated a money fund which promised to 
be for a shorter or longer period superfluous, which was not 
needed for any pressing uses in the present. 

The accumulation of such a fund requires two things, 
and the first is that a man must get money, must from some 
source derive an income. This is done, presumably, in the 
same way that a man obtains any income, by supplying either 
personally or through his property some service for which 
other men are willing to pay a price. 

The second requirement is that the man shall save from 
his income, shall practice abstinence. In doing this, he may or 
may not suffer serious deprivation : — the saving may be very 



92 



PRINCIPLES OF ECONOMICS 



difficult ; or it may be so easy, in view of his large income, 
that he finds it less sacrifice than spending. But this considera- 
tion has nothing to do with the case fundamentally, — the es- 
sential point being that, deprivation or no deprivation, he does 
relinquish the right to spend for present satisfactions. It 
should be noted also that the saver may or may not retain his 
savings for long as a distinct money fund. He cannot spend 
them, in the popular sense of the word, for consumption goods 
such as food, clothing, excursions, and the like, which go di- 
rectly and exclusively to the satisfying of present wants. But 
he' can part with the money in exchange for engines, houses, 
or other income-bearing property ; since, in doing that he mere- 
ly invests the money, and has in reality as large a sum of 
wealth as ever. This is a distinction famihar to the business 
world; but it is frequently overlooked and so becomes the 
source of a popular fallacy about money.* 

Bearing these distinctions in mind, the act or process of 
saving can have no deeper analysis. It is just saving, going 
without some gratification in the present which one might en- 
joy in the present if he chose. The capitaHst receives a money 
income; he spends part of it consumptively, but refrains from 



* Before leaving this point, a word of caution ought to be added. 
In insisting that capital has its origin in saving, we must not forget 
what has been brought out in another connection, that the supplying 
of capital involves, not merely the accumulating of a fund of money 
or credit, but also the actual, mechanical producing of the concrete or 
goods capital — ^the engines, carsi, machines, etc. We cannot furnish 
power or carry ore or make nails with stores of money, — we must 
have real engines and cars and machines. Nevertheless, this way of 
looking at the matter, which fits the needs of technical production, 
gives us no light on the origin of capital. The technical making of 
any particular piece of capital does not originate that capital. As re- 
marked above, the man who is really responsible for the existence of 
the capital is the one who accumulates the fund of money; and the 
conditions which he has to fulfil in accomplishing this disclose the 
fundamental nature of the process whereby capital comes into exist- 
ence. 



EFFICIENCY OF FACTORS 93 

spending the rest — holding it as money or investing it ; in con- 
sequence, he accumulates a fund with which he himself, or 
some one else to whom he lends it, can buy. engines or other 
productive goods. As economic society is at present consti- 
tuted, this is substantially the only process in which capital 
grows : get an income; save from that income. But, since the 
existence of an income is impHed in the saving from it, we 
may cover the whole problem in a single statement : under the 
existing economic order capital originates chiefly in saving or 
abstinence. 

IivIvUstrative; PROBr,E;MS 

1. Suppose that a community of say 50,000 persons living 
on an island, completely isolated from all other communities, 
but otherwise living under an economic system like ours, with 
division of labor, trade, metallic money, etc., should attempt 
to increase its capital by issuing $100,000 of paper money. 

(a) Argue for the contention that, in general, we should 
expect this attempt to fail, 

(b) Try to find some reasons for thinking that the 
scheme might realize a small measure of success. (Would 
said scheme tend to increase the total output of labor services? 
Would it tend to release any labor hitherto devoted to the old 
tasks ?) 

(c) Change the hypothesis by supposing the given com- 
munity to be in free trade relations with many other commu- 
nities, and argue that the proposed issue would really increase 
the capital of the community. 

2. "When the primitive fisherman refrains from eating 
fish in order to accumulate a store to be eaten while he makes 
a net, we obviously have a case of real saving. But when a 
capitalist keeps his money rather than spending it, things are 
very different. The good things our capitalist refrains from 
consuming have not been made at all ; instead, producers, 
knowing that capital is being accumulated, are making engines, 
cars, etc., which obviously could not be consumed. But, if 



94 



PRINCIPLES OP ECONOMICS 



they could not be consumed, they could not be saved, such 
capital, therefore, does not result from saving." 

Taking as your definition of saving this : "Saving is going 
without something one might otherwise enjoy," show that the 
capitalist who accumulates a fund of money does really save. 

3. Suppose that, instead of proceeding as at present, the 
capitalist were himself to make the concrete pieces of capital, 
hoes, plows, planes, engines, etc., and then lend these to pro- 
ducers for hire. Would such making of capital involve sav- 
ing? 

4. Suppose that a communistic state, in order to increase 
its stock of capital, should proceed to require from every citi- 
zen one more hour of labor daily. Would this way of build- 
ing capital involve saving? 

We have seen that capital comes into existence chiefly 
through saving, abstinence — a deliberate relinquishment of the 
present disposal of income. What conditions favor the prac- 
tice of this line of conduct? 

One condition certainly would seem to be the existence of 
large incomes. It is very hard for people of small incomes 
to save anything, and hard for those with moderate incomes 
to save much ; all they can get together is urgently required for 
their immediate wants. People with large incomes, on the 
contrary, are able to save with ease, simply because there re- 
mains a considerable surplus after their immediate, pressing 
wants have been satisfied. But what conditions are favorable 
to the existence of large incomes? Doubtless the most essen- 
tial condition is the one we are discussing, namely, high pro- 
ductive efficiency. The man who produces by ineffective 
methods will naturally have but a small product, and hence 
will need to consume most of it for each day's sustenance. The 
primitive fisherman, equipped only with his pair of hands, 
commanded a very small income of fish ; and so it was only 
with the greatest difficulty that, while feeding himself today, 
he could save anything for tomorrow. But, once possessed of 
a canoe and a net, the capitalistic method of fishing enabled 



EPPICIENCY OF FACTORS 95 

him to catch in a day far more than the day required, and 
hence to save from it much and easily. 

A second condition, or set of conditions, favorable to sav- 
ing is one which insures to capital the expected advantage of 
saving. As in the case of labor, the first assurance of an ap- 
propriate reward must spring from the existing system 
of distribution. But there are other sources. A man 
will have more inclination to save under a strong 
and beneficent government, where he feels confident his 
accumulations will not be taken from him by theft, invasion, 
or extortion. He will save most, too, in a flourishing coun- 
try, where the industries have become highly capitalistic, so 
that every smallest addition to his surplus can readily find a 
use, and that at a rate of interest fairly high, 

A third condition inducing men to abstinence is the ex- 
istence of social machinery suitable to aid in caring for, and 
investing, their accumulations. A public banking institution 
with burglar and fire-proof vaults conduces to saving, because 
one can entrust his accumulations to this, and be relieved of 
all anxiety as to their safety. Banks, also, offer strong in- 
ducements of another kind, in that they find for the capital- 
ist an opportunity to invest. An ordinary producer knows well 
enough how to practice abstinence, he can save his hundred 
dollars, or his dollar, or his dime a day ; but in a complex in- 
dustrial society like ours he is usually helpless about turning it 
to use. He sees no business near at hand requiring his sav- 
ings, and he cannot set out to seek one that does. Even if he 
found one, he would have no capacity for judging of its 
soundness. Furthermore, his savings may be very small, and 
such sums as he could offer would be so inadequate that no 
business man would bother to accept them. A bank, on the 
contrary, is a careful student of business enterprises, and an 
expert judge of their soundness, so it can take off the saver's 
hands all the trouble of finding an investment. And, finally, 
since it can merge his small savings with many other small 



96 PRINCIPLES OP ECONOMICS 

ones,* it can quite readily put them to use, and so still further 
encourage him to save. 

A fairly adequate general answer to our question can be 
put in a single sentence : The accumulation of capital is fav- 
ored by the existence of large incomes, by conditions which 
insure to capital the expected advantages of saving, and by 
the presence of suitable social machinery to aid in caring for 
and investing accumulations. 

Illustrative Problems 

1. Give reasons for expecting capital to accumulate more 
rapidly in England than in Scotland, in Germany than in 
Persia. 

2. Suppose the total income of industry in the United 
States were divided equally among all the citizens, do you 
think capital would grow as rapidly as it now does ? Why ? 

3. Explain why postal savings banks would be expected 
to increase the accumulation of capital; same for loan and 
trust companies ; same for insurance companies. 

4. From our present standpoint, argue for or against the 
Oklahoma system of guaranteeing bank deposits. 

We have examined the first requisite of efficiency on the 
part of capital — an abundant supply. A final question re- 
mains : how, after capital has been abundantly saved, can it 
be made available for those who need and are competent to 
use it? 

When a man himself uses the capital which he saves, this 
question has no pertinence. But, in modern industry, capital 
is generally saved by one set of men and used by another. 
Availability therefore turns upon how the two parties can get 
together, how lending can be made easy on the one side and 
borrowing on the other. The first part of this question has 



*A bank, of course, utilizes not only the funds which people 
have definitely set apart to play the role of capital, but also a great 
amount of wealth which is only momentarily idle. 



EPFICIENCY OP FACTORS 97 

already been answered : lending is made easy by the existence 
of institutions which specialize in that type of work. But 
borrowing is made easy in precisely the same way. Where 
good banking institutions exist the business man desiring cap- 
ital knows at any moment where a fund lies waiting for in- 
vestment; and so he can present his demand at this single 
place, instead of hunting out the individual capitalist — or per- 
haps many small capitalists. He is also spared the trouble 
of proving his soundness to each small holder — many of whom 
are anyway unable to judge — and furnishing security to satis- 
fy them. He can prove his soundness once for all before 
men well qualified to judge, and obtain the whole sum desired 
without further difficulty. 

As under the preceding head, the general conditions for 
rendering capital available can be put in a single sentence: 
The availability of modern capital depends on a high state 
of entrepreneur credit and high efficiency in the institutions 
which deal in money capital — banks, trust companies, and 
so on. 

I1.1.USTRAT1VE; ProbIvi;ms 

1. For some years before and after 1892, it looked to 
European observers as if the United States were likely to give 
up the gold standard and adopt silver, thus reducing the value 
of the dollar, as most expected, by about forty per cent. What 
effect would you expect this condition to have on foreign cap- 
ital in the United States? 

2. The existence of the ordinary commercial bank enables 
us to make available quantities of money capital out of funds 
which are not really set aside for use as capital, but rather are 
being kept for daily use. Try to explain how that can be. 
( Suppose that 500 persons kept the funds which they expect to 
put to everyday use in a bank, and made payments partly by 
cash drawn out, partly by checks drawn in favor of one an- 
other. Show that the bank could safely treat a considerable 
part of the funds as if they were going to be permanently 
idle.) 



98 PRINCIPLES OP ECONOMICS 

3. In Germany there are many agricultural loan associa- 
tions which issue jointly-guaranteed bonds to the lending pub- 
lic, then lend to their members on ordinary mortgage security. 
Does it seem likely that this system would tend to make capi- 
tal more available to farmers? 

Section D. Efficiency in Respect to the Entrepreneur 
Function 

As has already been made clear, the central function in all 
production is that of the entrepreneur, the person, natural or 
legal, who undertakes any particular business, — assumes the 
responsibility of bringing it into existence, or, anyhow, of 
continuing it. This of necessity requires that he shall carry 
the major part of the risk involved and that he shall himself 
perform certain fundamental managerial duties. What con- 
ditions, now, are necessary to enable entrepreneurs to serve 
efficiently in these functions? 

There are three chief requisites of efficient enterprising, 
(i) an adequate supply of land, labor, and capital, (2) judg- 
ment and foresight in recognizing opportunities for business 
undertakings, and (3) a spirit of enterprise, or initiative, — 
readiness to assume the responsibilities of production when 
an opportunity is recognized. The first item calls for little 
comment. Since the entrepreneur achieves all his results in 
production by using the other factors, his efficiency will nat- 
urally depend on having them to use ; but all questions relat- 
ing to the supply of other factors are well enough treated in 
the pages immediately foregoing. The second and third requi- 
sites are perhaps also self-explanatory; but the conditions 
which foster them in a community are, owing to the central 
position and the signal importance of the entrepreneur func- 
tion, worth a moment's examination. 

The qualities of judgment and foresight in recognizing 
good opportunities are in great measure matters of natural 
endowment. They exist apparently in some men and some 



EFFICIENCY OF FACTORS 99 

races, and in other men and races they are absent. On the 
other hand, they are to some extent capable of being taught; 
and, to that extent, those countries will have the greatest fund 
of entrepreneur power which employ the best methods of 
teaching it. A community successful in business and largely 
given up to business activities and ideals will unconsciously 
educate itself. By example, on the one side, and imitation, on 
the other, it will inevitably disseminate knowledge to all class- 
es of people, and pass down a gradually accumulating store 
from generation to generation. But, further, business can be, 
and, as thinkers are beginning to realize, should be, made a 
subject of formal study. Recent years have brought an enor- 
mous development in this line : the conditions underlying and 
surrounding business successes are analyzed, statistics are 
compiled and weighed, and the general principles of econo- 
mics are used in the solution of practical business problems. 
Facilities have also been created for supplying this scientific 
information methodically to any one who wishes to obtain it. 
The output of business books has been a striking phenomenon 
of the last decade, while colleges have grown up which teach 
not only the broader economic principles upon which business 
is based, but also the very details of business method. It is not 
unreasonable to expect that by these means the ability of men 
in general to recognize and estimate good opportunities will be 
markedly increased — in other words, that the entrepreneur 
function in production will be made more efficient. 

The third quality essential in entrepreneurs was described 
as enterprise, initiative, or readiness to assume the re- 
sponsibilities of production. If a country fails to develop men 
of the peculiarly adventurous type who are willing to assume 
the responsibilities of production, the entrepreneur function in 
that country will be very poorly performed. In consequence, 
since the co-operation of all other factors depends on the en- 
trepreneur, the country may have abundant natural resources, 
labor power, and capital, but until men appear — perhaps com- 



loo PRINCIPLES OP ECONOMICS 

ing in from other countries — who dare to attempt great com- 
binations of these factors, industry will remain at a standstill. 
The enterprising spirit, like good judgment, may in part 
be attributed to natural endowment — ^Western races are, or, 
until the recent rise of the Japanese, were assumed to be, more 
enterprising than Eastern. But probably in greater part this 
quality depends upon external fostering conditions. Thus, 
something less than a century back, the unlimited-liability 
partnership form of co-operative undertaking was much the 
most common. Under this form, a man starting a new enter- 
prise which might, for all he knew, result in failure, stood to 
lose all he owned. At the present time, the form of organi- 
zation more commonly used is one possessing the characteris- 
tic of limited-liability: the members are responsible for the 
debts of the organization, not to the full amount of their prop- 
erty, but only to a strictly defined sum — the sum they have put 
into the business, or perhaps that and as much more. Natur- 
ally, under the latter conditions, rather than under the for- 
mer, men will venture upon new and dangerous enterprises. 
Again, where the risk of undertaking enterprises is great, 
men must have some assurance that in case of success their 
gains will be correspondingly great. The patent laws must be 
effective, so that when a man launches on the market an untried 
article he will not be robbed of his unusual gains by others 
who manufacture the same article as soon as the dangers have 
been overcome. A man must know also that his property will 
not be destroyed or stolen by people whom the government 
cannot control, and that his profits will not be taken from 
him through merciless taxation imposed by the government 
itself. Finally, the spirit of enterprise is certain to assert it- 
self more freely where some kind of machinery, legal, and 
industrial, exists to help it. Thus, in earlier times, corpora- 
tions came into existence only by a special act of the Legis- 
lature ; in our day they are formed much more readily by ad- 
ministrative process under the authority of a general law. 



EFFICIENCY OF FACTORS loi 

Every large city has also nowadays a stock exchange where 
the shares of corporations are daily bought and sold, thus re- 
ducing the task of acquiring control of an enterprise to a sim- 
ple market transaction. 

The conclusions of all this part of our discussion may now 
be summarized as follows : High productive efficiency in re- 
spect to the entrepreneur function, in so far as it is not a 
■matter of natural endowment merely, depends chiefly on the 
maintenance of conditions which (i) minimize the individual 
risk-burden of undertaking, (2) make possible the quick and 
easy entry into, and withdrawal from, enterprises, and (3) 
provide or permit large profits where risk is unavoidably 
great. 

Illustrativk Problems 

1. Give two or three ways in which patent right laws con- 
tribute to productive efificiency. 

2. There is much to be said in condemnation of our reck- 
lessness in permitting private individuals to exhaust our vast 
stores of natural wealth in gold, silver, oil, copper, etc. 

What can be said on the other side? 

3. Was there any excuse for the great liberality displayed 
in the granting of trolley car franchises in the late eighties ? 

4. Argue for the contention that a much more efficient 
protection of the public against dishonest promoters of min- 
ing and other enterprises would contribute greatly to produc- 
tive efficiency. 



CHAPTER VII 

INCREASE IN OUTPUT AND RATE OF 
PRODUCTION 

Looking at the situation broadly, Man finds himself set 
over against a natural world, from which through his own 
efforts and sacrifices he can and must make himself a living, — 
can and must produce the goods necessary to life and happi- 
ness. This natural world over against which he is set, and 
from which he must wrest a living, is practically a fixity : even 
from the standpoint of many generations, it experiences no 
increase in volume or capacity; indeed as respects important 
raw materials, it even shows a diminution. On the other 
hand, population in most countries, certainly in the world as 
a whole, constantly increases. It follows that, from a natural 
plant which is practically unchanging, an ever-increasing out- 
put of economic goods must be produced. In this situation, it 
becomes of much importance that we should study the results 
which follow our efforts to increase output, and ascertain, as 
far as we may, to what extent and in what degree these efforts 
are likely to be successful. 

Certain aspects of this problem have already been touched 
upon, at least by implication, in discussing productive efficien- 
cy. In view of the fact that different policies in the conduct 
of production result differently in respect to the volume and 
goodness of product, it, of course, follows that we can increase 
total output for any given period over that of some earlier 
period, provided that in the earlier period we have pursued 
a less efficient policy and are now in a position to resort to the 
more efficient one. Further, as discovery and invention sup- 
ply us with new methods and policies which are more efficient 
than the old ones, we can increase total product by resorting 



OUTPUT AND RATE OF PRODUCTION 103 

to these new methods and poHcies. But these considerations, 
though of great importance, are too evident to need any pro- 
longed discussion. There is a much more difficult body of 
doctrines having their root in the fact that changes in the pro- 
portions in which the factors of production are combined are 
quite sure to cause changes in the quantity of product ob- 
tained per unit of any one of the factors. Setting two men 
to work a piece of land hitherto worked by only one would 
probably mean a larger total product; three workers might 
make the product still larger; and so on; though the time 
would doubtless come when additions to the amount of labor 
expended ceased to increase product, perhaps even reduced it. 
Moreover, even while output was being increased, the chang- 
es would probably not be uniform. The increases might be 
more than proportional to the increases in the labor, or just 
proportional, or less than proportional. Here, evidently, we 
have a very fundamental problem. Further, it is a problem 
which, though seeming elementary enough in this simple state- 
ment, contains, as we shall find, a veritable nest of complica- 
tions. 

I. General Solution of Problem for Individual 
Productive Instruments 

As already indicated, our problem is of most significance 
when we are thinking of a whole people over against its total 
outfit of natural resources ; but, manifestly, we could not ex- 
pect to obtain light on this larger question unless we had made 
some study of the behamor of individual units of our produc- 
tive factors. In order to learn how the total outfit of a na- 
tion will react when we try to increase its total production by 
spending more effort upon it, we must first ascertain how a 
particular piece of land or a particular machine or a partic- 
ular power plant behave under similar treatment. According- 
ly, this chapter is devoted to answering the question : What re- 
sults in respect to output when we try to increase the output 



I04 



PRINCIPLES OP ECONOMICS 



from any instrument of industry by increasing the quantity 
of the auxiliary factor or factors combined with it? 

In making a general answer to this question, let us sup- 
pose ourselves to experiment with a common hot-air furnace 
of the size adapted for heating a i2-room house, and to ask 
what results we should get from using for each experiment a 
larger charge of coal than for the preceding one, the total 
quantity to be applied in a period of two hours. If, for ex- 
ample, we were to make our first experiment using lo pounds 
of coal, in the next one 20, in the next 30, and so on, we may 
be pretty sure that the results would be something like the 
following. The first experiment would probably deliver no 
appreciable amount of hot air, — the heat produced being all 
absorbed by the furnace itself and the conducting pipes. The 
second experiment with 20 pounds of coal might supply 
enough heat to raise a room of 200 cubic feet to 70 degrees. 
The 30-pound experiment might raise to the same tempera- 
ture twice as much space, though the amount of coal used was 
only one-half greater. The 40-pound experiment might heat 
1,000 cubic feet, two and one-half times as much as the 30- 
pound test, though the increase in coal was only one-third. 
This more than proportional increase in the work done might 
continue for several more experiments. But presently a test 
would come which, though showing some increase in the total 
work accomplished, showed an increase less than proportional 
to the increase in the charge of coal. Thus the 80-pound test 
might give us heat for 8,000 feet, while the 90-pound gave us 
only enough for 8,800 feet: — the coal used increasing one- 
eighth, hut the work done increasing only one-tenth. Finally, 
after this less than proportional increase in work had gone on 
for some time, a point would be reached when a larger amount 
of coal would smother the fire and actually diminish the 
amount of heat delivered. To summarize, as soon as our com- 
binations began to give results at all they would fall into three 
groups : ( I ) Output increasing more than proportionally to the 



OUTPUT AND RATE OF PRODUCTION 105 

increase in the auxiliary factor (coal) ; (2) Output increasing 
less than proportionally; and (3) Output diminishing. For 
convenience in reference, let us call this the Principle of the 
Three Stages. 

In the above paragraph, the heating furnace supplied an 
illustration easily understood and one in which the truth of 
the conclusion laid down is so evident as to make proof unnec- 
essary. But it will scarcely be doubted that the same principle 
applies quite generally in economic production. If, for exam- 
ple, we were to take a ten-acre field devoted to raising pota- 
toes, and, in successive seasons, use in cultivating that field 
first I day's labor, then 5 days', then 10, then 15, and so on, 
we should doubtless get results analogous to those found in 
coaling the furnace. For several experiments the crop would 
increase more than proportionally to the increase in the la- 
bor, then less than proportionally, and finally would diminish. 

As to the existence of the first and third stages indicated, 
there surely is no room for doubt: the amount of labor used 
might be so small that increasing it would more than pro- 
portionally increase the crop, and the amount of labor might 
already be so great that increasing it would actually cut down 
the crop. As respects the second stage, some doubts have 
been expressed, but they seem to have little ground. The uni- 
versal practice of farmers in a matter so fundamental as this 
must surely be based on a trustworthy induction; and that 
practice fully confirms our contention that the second stage 
exists. First, farmers do not try to raise all the produce 
wanted on a single piece of ground. Instead, they use many 
pieces. But this they would not do, if the amount raised from 
one piece could be increased indefinitely at the same rate as 
the labor applied to it. Secondly, after having extended cul- 
tivation to inferior lands, they return to spend more labor on 
the superior ones, when the price rises high enough to war- 
rant spending the additional labor for a smaller proportional 
return. And this they would not do, unless the policy added 



io6 PRINCIPLES OP ECONOMICS 

something to the crop. There is a stage, then, in which out- 
put is increasable but not increasable in proportion to the in- 
crease in the auxihary factor. 

2. Illustration from an Imaginary Experiment 

The above account of the general principle underlying the 
behavior of individual industrial factors when we try to in- 
crease output by increasing the quantity of assisting factors, 
is so obviously true for such cases as those considered, so 
much a matter of everyday experience, that we would almost 
seem justified in omitting its further discussion. In fact, how- 
ever, the topic is extraordinarily prolific in misunderstand- 
ings; so much so that it seems necessary to spend considera- 
ble effort in trying to insure a clear, accurate comprehension 
of the doctrine itself and the various corollaries and conse- 
quences derivable from it. To this end, we shall ask the stu- 
dent to follow the assumed results of an imaginary series of 
experiments, embodying the working of things in very defi- 
nite and detailed arithmetic form. 

In this series of imaginary experiments we use each time 
20 units of one of the factors which we will call N and com- 
bine with these, increasing quantities of another kind of fac- 
tor which we will call L, using first 2 units of these Ls, then 
3 units, the next time 4 units, and so on. In our table, the 
first column shows the number of the combination of which 
there are 27 in all; the second gives the number of Ns used 
in the combination indicated, in every case 20, by hypothesis ; 
the third column shows the number of Ls used, 2 in the first 
combination, 3 in the second, 4 in the third, and so on ; and the 
fourth column gives the total number of units of output for 
the particular combination, for example, the fifth combina- 
tion, using 20 Ns with 6 Ls, gives 84 units of product, the 
ninth combination, using 20 Ns with 10 Ls gives 200 units of 
product. 



OUTPUT AND RATE OF PRODUCTION 



107 



The fifth column has two sets of figures, one in parenthe- 
sis, the other not. The former shows what the increase in out- 
put would have been, if it had been just proportional to the in- 
crease in the number of Ls, while the second set — those with- 
out parentheses — show what the increase actually was. The 
first, the figures in parenthesis, are derived, for any particular 



S. 

^0 


< 


d 
< 


-1-3 



Propor. 

Increase 

Actual 

Increase 


W) CO 

1-^ 




bo cc 

< 


Marginal 

Product 

of Ls 


I 


II 


III 


IV 


V 


VI 


VII 




VIII 


1 


20 


2 


2 






.1 


1 






2 


20 


3 


6 


(1) 


4 


.3 


2 




4 


3 


20 


4 


16 


(2) 


10 


.8 


4 




10 


4 


20 


5 


35 


(4) 


19 


1.7 


7 




19 


5 


20 
20 


6 

7 


84 
126 


(7) 
(14) 


49 

42 


4.2 
6.3 


14 
18 




49 


6 




42 


7 


20 


8 


156 


(18) 


30 


7.8 


19.5 




30 


8 


20 


9 


179 


(19.5)23 


8.9 


19.8 


- 


23 


9 


20 


10 


200 


(19.8)21 


10 


20 


21 


10 


20 


12 


236 


(40) 


36 


11.8 


19.7 


18 


11 


20 


14 


266 


(39) 


30 


13.3 


19 




15 


12 


20 


16 


290 


(38) 


24 


14.5 


18.1 




12 


13 


20 


18 


312 


(36) 


22 


15.6 


17.3 




11 


U 


20 


20 


330 


(34) 


18 


16.5 


16.5 




9 


15 


20 


22.2 


346 


(36) 


16 


17.3 


15.6 




7.2 


16 


20 


25 


362 


(43) 


16 


18.1 


14.5 




5.7 


17 


20 


28.5 


380 


(50) 


18 


19 


13.3 




5 


18 


20 


33.3 


393 


(63) 


13 


19.6 


11.8 




2.6 


19 


20 


40 


400 


(78) 


7 


20 


10 




1.1 


20 


20 


44.4 


398 


(44) 




19.9 


8.9 






21 


20 


50 


393 


(50) 


CO 


19.6 


7.8 




m 


22 


20 


57.1 


360 


(56) 


CD 


18 


6.3 






23 


20 


66.6 


280 


(60) 


a> 


14 


4.2 






24 
25 


20 
20 


80 
100 


140 

80 


(56) 
(35) 


Q 


7 
4 


1.7 

.8 






26 


20 


133.3 


40 


(26) 


< 


2 


.3 




<1 


27 


20 


200 


20 


(20) 




1 


.1 







io8 PRINCIPLES OF ECONOMICS 

combination, by noting the increase in the number of Ls for 
that combination, ascertaining what per cent of the number 
of Ls in the preceding combination this increase is, then com- 
puting what an equal per cent, of the total output of the next 
preceding combination would be. Thus, in the thirteenth com- 
bination, the Ls show an increase ov£r the twelfth combina- 
tion of 2 units, which is an increase of 2/16 or 12.5 per cent. 
But the total output of the twelfth combination was 290, and 
12.5 per cent, of this is 36. The latter figure, accordingly, ap- 
pears in the parenthesis under the thirteenth combination, 
showing that the increase in output would have been 36 units, 
if it had been proportional to the increase in the number of 
Ls used. 

The figures in this fifth column which are not in paren- 
thesis represent the actual increase in output, and are, of 
course, obtained for any particular combination by subtracting 
from the total of that combination the total of the combination 
next preceding. Thus from the 312 output of the thirteenth 
combination, we subtract the 290 of the twelfth and get 22, 
the actual increase for the former combination, and this fig- 
ure, therefore, appears in the fifth column outside the paren- 
thesis. (The remaining columns of the table will be explained 
later.) 

A brief inspection of our table will show that it repre- 
sents symbolically the phenomena which were set forth above 
as present in real life. No actual combinations of factors be- 
have in precisely the way indicated in this table ; but the gen- 
eral course of things is strictly regarded. We have but to 
follow the figures given in the fifth column to see that, for 
the first nine combinations, output increases more than propor- 
tionally; that, for the next ten combinations, it increases less 
than proportionally ; and that, for the last eight combinations, it 
absolutely dwiinishes. In short, it passes through the three 
stages through which real combinations pass. Accordingly, we 



OUTPUT AND RATE OF PRODUCTION 



109 



can safely use the figures of this table to bring out in definite 
and precise form the points directly or indirectly involved in 
our principle. 

Ili^ustrative; ProbIvEms 

1. If you had at your disposal 10 Ns and 8 Ls, what 
combination would you naturally use? What one, if you had 
40 Ns and 32 Ls? If you had 5 Ns and 4 Ls? 60 Ns and 75 
Ls ? How much, if you added another 6 Ls ? 

2. If you had at your disposal 60 Ns and 48 Ls, how 
much product would you naturally be getting? How much 
more would you naturally get, if you were to put in 6 more 
Ls? How much, if you added another 6 Ls? 

3. Changes Caused in Averages as Measured in 
Each of the Two Factors 

The next point to be remarked concerns the changes caused 
in the average output as measured in one or the other of 
the factors. This is, indeed, only another way of looking at 
the facts already presented, but it is a way of much interest 
and importance. How, then, does the average measured in Ls 
behave? The seventh column of our table shows that it in- 
creases up to the ninth combination, then diminishes to the 
end. Moreover, the table shows a perfectly definite reason 
why this must be so. The average output for any combina- 
tion, measured in Ls, is, of course, equal to the total output 
for that combination divided by the number of Ls used in the 
combination. But, if for any series of combinations the total 
output is increasing more rapidly than the number of Ls, (as 
it is for the first nine combinations), the quotient obtained, 
that is, the average, must be increasing. On the other hand, 
if for any series of combinations the total output is increasing 
less rapidly (as it is for the ten combinations after the ninth), 
than the number of Ls, the quotient, and so the average, must 
be diminishing. Finally, if output is diminishing absolutely 
while the number of Ls is still increasing, the average must of 



no 



PRINCIPLES OP ECONOMICS 



course be diminishing. The average, measured in Ls, there- 
fore, first increases up to the ninth combination, then dimin- 
ishes to the end. 




The behavior of the average measured in Ns, as repre- 
sented in the sixth column, is necessarily somewhat different. 
Since the total output is increasing up to, and including, the 
nineteenth combination, while all the time the number of Ns 
used remains constant, — ^that is, since the dividend increases 
while the divisor remains constant — the average, measured 
in Ns, must increase throughout this series. On the other 
hand, since the total diminishes after the nineteenth combi- 
nation while the number of Ns remains constant, the average, 
measured in Ns, must diminish after the nineteenth to the 
end. 

Summarizing the points made above and the most imme- 
diate inferences therefrom, we have the following. First, 
each average rises during a series of combinations ; reaches a 
maximum in one particular combination ; then diminishes for 
the remainder. Secondly, the maximum average combination 
is different for the two averages, being an early one for the L- 
average, a late one for the N-average, — a proposition which 
plainly follows from the conditions. In the third place, the 
average measured in either factor is bound to be an increasing 



OUTPUT AND RATE OP PRODUCTION m 

one for every combination prior to the tenth; that average 
measured in either factor will be a diminishing one for every 
combination after the nineteenth ; and, for the intervening com- 
binations, the average will be a diminishing one, measured in 
Ls, but an increasing one, measured in Ns. These points are 
brought out graphically in the accompanying diagram, in 
which the continuous curve represents the averages measured 
in Ls, while the dotted curve represents the averages meas- 
ured in Ns. 

4. Changes in Additions or Marginal Products 

Another effect of attempting to increase output by increas- 
ing one of the factors, concerns the changes caused in the ad- 
dition to output as measured in the addition to the changing 
factor. Thus the thirteenth combination shows an increase 
over the preceding one of 22 units of output, while the num- 
ber of Ls added to make this combination was 2 ; and, divid- 
ing 22 by 2, we have 11, which is the number of units of prod- 
uct added for each of the Ls added. With some show of rea- 
son, this quantity is frequently designated the marginal prod- 
uct of the Ls — that is, of the increasing factor. Anyhow, the 
course which it takes as we increase the quantity of Ls used 
is of considerable importance. That course is indicated in the 
last column of our table. It begins at 4 in the second combina- 
tion; increases to 49 in the fifth; from thence grows smaller 
and smaller to the nineteenth; after which it remains less 
than zero. 

These results are inevitable so long as the relation between 
the increase in output and the increase in the number of Ls is 
the exact relation assumed in our table. The addition to out- 
put for each added L is just what it is because the relation 
between the increase in the total output and the increase in the 
total numxber of Ls is just what it is. We must not infer, 
however, that the precise course taken by the marginal addi- 
tions in our table is the only one which they could take under 



112 PRINCIPLES OP ECONOMICS 

the general conditions assumed, namely, the conditions that 
output increased more than proportionally up to the ninth 
combination inclusive, then less than proportionally to the 
nineteenth, and then diminished. The precise course taken by 
the marginal addition or product as a result of a change in the 
proportion between output and the number of L,s, depends, 
not only on the direction of that change, but also on its de- 
gree. Thus, if the proportional increase in output had been 
less rapid during the earlier combinations or had fallen off 
less sharply in the later ones, the change from an increasing 
to a diminishing marginal product would have come later. 
Other possible variations in the behavior of the marginal 
product from that indicated in our table could easily be worked 
out arithmetically. Nevertheless, if we assume that the course 
taken by the output in our imaginary experiment was 
fairly typical, — and I think we may properly do so, — the 
course taken by the marginal product would correspond in a 
general way to that which it takes in our table : that is, mar- 
ginal product would increase up to a maximum coming some- 
what earlier than the combination at which the increase in out- 
put became less than proportional, then diminish to the end. 
Before leaving this topic, we must emphasize one aspect of 
the matter just commented upon, — the fact that the point 
where marginal product begins to diminish does not corre- 
spond with the point where the increase in output changes 
from a more than proportional to a less than proportional 
one, — the latter being at the tenth combination, the former at 
the sixth. As already noted, this precise location of the point 
at which the marginal product begins to decline is not neces- 
sary for every possible case in which the increase begins to be 
less than proportional at the tenth combination. In other 
words, our experiment does not prove that a locating of the 
change in marginal product at a point earlier than that at 
which the change in proportionality takes place is inevitable: 
it does prove, however, that this is possible, if not probable. 



OUTPUT AND RATE OF PRODUCTION 113 

It follows that we can not properly treat the two phenomena 
as identical. The principle that the marginal product first in- 
creases, then diminishes is not the same as the principle that 
output increases more than proportionally to the changing fac- 
tor, then less than proportionally.* 

5. Factor L Constant, Factor N Changing 

In our imaginary experiment as embodied in the table, the 
quantity of Ns was supposed to be constant while that of Ls 
increased. What, now, would be the result were this situation 
to be reversed with the Ls constant and the Ns increasing? 
It would be precisely similar to that already brought out with 
the places of Ns and Fs reversed. Output would increase at 
first more rapidly than the Ns, then less rapidly, then actually 
decrease; the average, measured in Ns would increase up to 
some early combination, then diminish to the end, while the 
average, measured in Ls would increase up to some later com- 
bination, then diminish to the end; and, finally, the marginal 
additions, the marginal product of Ns, would increase up to 
some combination prior to the ninth, then diminish to the end. 
And note that the acceptance of these statements does not de- 
pend on a new induction. // the points made with respect to 
the results which follow when Ns are kept constant and Ls 
increased, are true, the analogous statements with respect to 
the results which follow when Ls are kept constant and Ns 
increased must be true. A table reversing the relations of Ls 
and Ns, in respect to both conditions and results is directly 
deducihle from the table already given. Accordingly, in so 
far as the doctrines set forth in the preceding discussion ap- 
ply to any particular combination, they are true without regard 
to which of the factors is kept constant and which is increased. 
If they are true of a combination of land and labor in which 



* This comment is necessary on account of occasional carelessness 
of statement on this point in the literature of our subject. 



114 PRINCIPLES OF ECONOMICS 

the land is constant, they are equally true of one in which the 
labor is constant. 

The point just made that the principles laid down with re- 
spect to the effect of increasing one of the factors of a com- 
bination while the other remains constant are true whichever 
one of the factors is increased, must not be understood as im- 
plying that it is of no practical importance which factor is 
taken as the constant one. Some natural factors in produc- 
tion and many produced ones necessarily appear in large, in- 
divisible units. They must be utilized as a whole or not at all. 
For example, the group of great lakes beginning with Superior 
and ending with Ontario, — a very important factor in trans- 
portation — can not be made smaller or larger. We must use 
the system as it is. So a plant for lighting a great city or sup- 
plying it with water can not be changed every week or month 
or year. If we have to increase or diminish the amount of 
service obtained from factors of this type, we must for a 
time if possible do so by increasing the quantity of aux- 
iliary factors used. Such increasing of the auxihary factors 
is usually possible, because those factors are to be had in 
small or easily divisible units. While we can not increase 
the size of the lakes, we can change in no great length of time 
the number of boats navigating those lakes. While we can not 
at frequent intervals enlarge the whole lighting plant, we can 
readily increase the amount of labor employed or the quantity 
of coal consumed. The importance of the principles brought 
out in this chapter grows out of their application to cases like 
these in which one of the combining factors is naturally or, 
necessarily kept constant for a shorter or longer period, while 
the others may be changed. / 

6. Output from Groups of Factors 

We have noted the effect on output of* increasing one of 
the factors of a combination when we are dealing with single 
factors. We have to add that the same phenomena appear 



OUTPUT AND RATE OF PRODUCTION 115 

when we are dealing with groups of factors over against one 
or more auxiliary factors. Thus, when trying to ascertain 
the effect on output from the aggregation of land, buildings, 
machinery, etc., which we call a plant, of increasing the 
amount of auxiliary factors, raw materials, fuel, labor, etc., 
we have the same general experience as before. For a time, 
the output increases more rapidly than the auxiliary factors, 
then less rapidly, then absolutely diminishes. 

The same statement would of course apply to a business 
imit as a whole, that is, a partnership or a corporation oper- 
ating one or many plants. This would be so, partly because 
the plants operated by the corporation would exhibit the phe- 
nomena in question and partly because the organization side 
of the business would independently exhibit these phenomena. 
While parts of the organization remained constant — ^for ex- 
ample, the higher officials, one president, one secretary, and 
one general manager, — other elements would be increased, and 
this increase would at some stages result in a more than pro- 
portional increase in output and at others in a less than pro- 
portional one. 

In general, then, it is scarcely to be doubted that we have 
here a principle or set of principles of very wide application. 
Barring chemical combinations, which permit of no variation, 
we may in almost all cases alter the proportions in which fac- 
tors are combined without destroying their power to produce ; 
but we zmll change their effectiveness or productivity, making 
them produce, proportionally, more or less. And this fact will 
be of importance whenever the circumstances are such that 
some one factor or group of factors is absolutely fixed, or, for 
a longer or shorter period, is fixed by special circumstances. 



CHAPTER VIII 

INCREASE IN OUTPUT AND SOME ECONOMIC 
CONSEQUENCES 

In the last chapter, we explained the more immediate and 
chiefly technical consequences resulting from attempts to in- 
crease the output from a factor of production by increasing 
the amount of the auxiliary factors employed. We must now 
remark on some remoter consequences, — especially some of 
an economic character. 

I. Limits of the Productive Capacity of Individual 
Instruments 

As noted in introducing our last chapter, one of the most 
important economic problems connected with the matter we are 
now studying concerns the limits of our productive capacity. 
In so far as this inquiry has to do with the individual in- 
strument, the most valuable conclusions of our study are 
these two : ( i ) there is an absolute limit to the amount obtain- 
able from any instrument, and (2), before that absolute limit 
is reached, there is a stage during which the increase in 
output is less than proportional to the increase in 
the quantity of auxiliary factors. On account of its great 
importance, the second of these ought, perhaps, to be given 
the emphasis derivable from its statement as a formal prin- 
ciple. This principle is commonly known as The Law of Di- 
minishing Returns. 

Principle of Diminishing Returns. // attempts are made 
to increase indefinitely the output of any factor of production 
by increasing the quantity of auxiliary factors used, a time 
will come, before the absolute limit is reached, when the in- 
crease in output is less than proportional to the increase in 
the quantity of assisting factors used. 



INCRBASB IN OUTPUT: CONSEQUBNCBS 117 

One word now with respect to certain technical phrases 
used in connection with the principle just stated. When the 
utilization of any instrument of production has been carried 
up to the combination which will yield only a smaller propor- 
tional return, it is said to have been worked or utilized to 
"the point of diminishing returns." A step further takes it 
beyond the point of diminishing returns or into the stage of 
diminishing returns. As the utilization of any instrument is car- 
ried further and further into the stage of diminishing returns, 
it is said to be worked (cultivated in the case of land)"wf^n- 
sively" or "more intensively" . Another method of expressing 
the same idea is to say that "the margin of cidtivation (utiliza- 
tion) is lowered" or "pushed down". 

The discussion leading up to the above statement of the 
principle of diminishing returns has, perhaps, insured its cor- 
rect interpretation. In view, however, of numerous misunder- 
standings which have appeared in economic controversy, it 
seems best to indicate specifically certain misinterpretations 
which need to be guarded against. First, the "returns" referred 
to in the designation "diminishing returns" are physical re- 
turns, — product, not money or profits. The principle means 
that, by increasing the amount of labor we can increase, though 
less than proportionally, the potatoes raised on a given piece of 
ground, or the heat given out by a furnace, or the freight car- 
ried by a railway, and so on. 

In order to emphasize this point, I like to call our principle 
The Law of Diminishing Output, thus avoiding the ambiguity 
attaching to the word "returns". 

Another misunderstanding confuses the principle now un- 
der discussion with one which says that there comes a stage 
in the production of goods when product can be increased only 
at increasing cost. This statement is without doubt true ; but 
the condition indicated is not identical with the one meant when 
we say that we have reached the stage of diminishing returns. 
In using the latter characterization we are measuring the in- 



ii8 PRINCIPLES OF ECONOMICS 

crease in output only in terms of the changing factor. In con- 
sequence, we can treat diminishing output and increasing cost 
as reverse aspects of the same thing, only on condition that 
cost is entirely covered by what zve spend for the changing 
factor. But of course this is not true. Our Ns must have a 
price as well as our Ls, otherwise they would not constitute 
an economic factor at all, and, so, would not come under our 
consideration. But, when cost is taken to include the outlay 
for Ns as well as Ls, the turning point from diminishing cost 
to increasing cost would rarely if ever coincide with the turn- 
ing point between increasing returns and diminishing cost. 
Thus, in the case represented in our table, the point where in- 
creasing returns were replaced by diminishing returns would 
always be at Combination lo; whereas the point where dimin- 
ishing cost was replaced by increasing cost would change with 
every considerable change in the relative prices of Ns and Ls. 
Thus, if Ns were worth $i and Ls $io, this point would be 
Combination 1 1 ; if Ns were worth $i and Ls $3, the point 
would be Combination 12; with Ns at $1 and Ls at $1.50, the 
point would be Combination 13. 

Another troublesome misunderstanding interprets our prin- 
ciple to mean that output could never be increased at a propor- 
tional rate whatever might happen, however much improve- 
ment in the productive arts might take place. This, of course, 
is a quite illegitimate interpretation. A natural law in Eco- 
nomics, just as in Chemistry or Physics or Biology, assumes 
the continuity of conditions other than the one or more which 
the principle itself represents as changing. Doubtless any per- 
son is at liberty to affirm a principle analogous to the one 
here considered in a dynamic sense, as we sometimes say, that 
is, as certain to prove true despite changing conditions. But 
most prudent people will hesitate to do so ; and anyhow, unless 
this is expressly indicated, the affirmation is always made sub- 
ject to the condition that no changes are to take place except 
the one specified in the principle itself, namely, an increase in 
the quantity of the changing factor. 



INCRBASB IN OUTPUT: CONSEQUBNCES ng 

2. Elasticity of the Limit Set by the Law of 
Diminishing Returns 

In our formulation of the Law of Diminishing Returns, and 
too often in our interpretation of that law, all emphasis is 
laid on the fact that it acts as a check on output, — sets a limit 
to output. Only a very little thought makes it clear that this 
principle has another side. It is true that output does not in- 
crease proportionally to the increase in auxiliary factors ; but 
then output does increase. If we have reached the stage 
of diminishing returns in the utilization of any instrument of 
production, we can not get any more product out of it at the 
same rate as before ; but we can get some more. In fact, our 
principle might with very good reason be named the Principle 
of Output Increasable at a Diminishing Rate. Such a designa- 
tion recognizes equally the fact that output can be increased 
and the fact that the increase will be less than proportional. 

3. All Divisible Factors Usually Being Worked in 
the Stage of Diminishing Returns 

We have seen that most economic factors are subject to 
the law of diminishing returns in the sense that, in trymg to 
utilize them more and more fully, a time will come when such 
attempts will increase product, but increase it less than pro- 
portionally. We now have to add that, under normal condi- 
tions, the utilisation of any divisible factor must have been 
carried into this stage, — producers must be working it in some 
combination beyond the point of diminishing returns. In terms 
of our table, any such instrument will at all times be work- 
ing in some combination later than the ninth and eariier than 
the nineteenth. 

The general argument on which the above statement is 
based is this : all combinations earlier or later than those in- 
dicated are excluded as being for one reason or another illegiti- 
mate. First, all combinations coming after the nineteenth must 
be excluded, since the additions to the changing factor which 



I20 PRINCIPLES OF ECONOMICS 

make up these combinations reduce the total, — a result which 
can be avoided by the simple expedient of not making those ad- 
ditions., Secondly, all combinations from the first to the eighth 
inclusive must be excluded; since, under our hypothesis that 
the factor under consideration is divisible, we could transform 
any one of these early combinations into the ninth by the 
simple expedient of discarding some of the Ns, and, in doing 
this, would increase our total. Thus, the seventh combination, 
20 Ns with 8 Ls, could be transformed into the ninth by dis- 
carding 4 of the Ns, making the combination i6 Ns with 8 
Ls, — the same 2 to i ratio as that of the ninth. But this com- 
bination would give us 8 times 20 or 160 units of product, 
whereas the original combination of 20 Ns with 8 Ls would 
give us only 156 units. 

We have seen that, under normal conditions, no divisible 
factor would be used in any combination later than the nine- 
teenth nor earlier than the ninth. That is, the actual, effec- 
tive working of any factor would be limited to some one of 
the eleven combinations from the ninth to the nineteenth in- 
clusive. But we must narrow still further the range of reason- 
able, and so actual, combinations. Another element neces- 
sarily comes in to determine what ones are possible, namely, 
cost of production. If Ns could be had in unlimited abund- 
ance for nothing, while Ls had a price however small, the 
ninth combination would plainly be the most desirable, since 
it gives the highest average measured in Ls, and so, when the 
price of the Ls constituted the only cost, the cost in this com- 
bination would be lowest.* On the other hand, if Ns had a 
price, but Ls none, the nineteenth combination would be the 
cheapest, and, so, the most desirable of all. But, in real life, 
both Ns and Ls will have some cost, else they would not be 
economic factors at all. Further, there will not often be such 
a difference between their costs that either is negligible in the 



* This would be true even if Ns had a price but one which was 
insignificant as compared with that of Ls. 



INCRBASB IN OUTPUT: CONSBQUBNCES 



121 



total cost. It follows that, if both factors are divisible, the 
truly legitimate combination will normally be one which comes 
later than the ninth and earlier than the nineteenth. Assuming 
reasonable conduct on the part of producers, they will be using 
any factor in some one of the combinations indicated, — the 
combinations lying between the ninth and the nineteenth. But 
any one of these is bound to be a diminishing-returns combina- 
tion, that is, one holding such a position that, if we try 
to increase output by increasing the quantity of auxiliary 
factors, we shall effect some increase but an increase which is 
less than proportional to the increase in auxiliary factors. We 
conclude, then, that, in actual life, we should expect to find 
any divisible factor being worked in the condition of diminish- 
ing returns. 

4. Indivisible Factors May Be Working in the Stage 
of Increasing Returns 

We have just seen that divisible factors will normally be 
used in the condition of diminishing returns, because on 
account of the divisibility of the factor which was 
kept constant in our experiments, we could always change to 
a later combination, and would do so if this was desirable. 
But, when we come to deal with indivisible or large-unit 
factors, the problem is greatly altered. Just because the 
given factor is indivisible, we can not adapt it promptly 
to every change in the need for product. Thus, it is plain 
that we can not change our furnace every time the weather 
changes, substituting a larger one if more heat is needed or a 
smaller one if less heat is needed. What we have to do is to 
run the one we have harder or easier, — put in coal oftener or 
less often. An obvious result of this situation is that, if the 
weather gets warmer, we may be obliged to run the furnace so 
low that it is being worked in some stage prior to the ninth, 
say the seventh or the fourth. This of course is uneconomical : 
we get much less heat per pound of coal than we might, if our 



122 PRINCIPLES OP ECONOMICS 

plant were adapted to just the need of the moment. But wc 
have no choice. We must install a furnace large enough to 
meet the need of really cold weather; and yet, on a moderate 
day, we must not work it hard enough to make the house un- 
inhabitable. It follows, then, that zve may find any indivisible 
factor being used in the stage of increasing returns, output in- 
creasable at an increasing rate. 

What we have just said of the furnace applies as well to 
any large natural factor, for example, the lake system used for 
illustration on page 114. Such a factor may be working in the 
condition of increasing returns or in that of diminishing re- 
turns. Which it will be depends -entirely on the existing need 
for the services of the factor. We have no choice in the 
matter. We have to use it as it is whether the need be great or 
small. For a long period while population was small, this vast 
system of waterways could be utilized only in some inferior 
combination, some one earlier than our ninth. With the in- 
crease of population during the last fifty years, it probably 
has passed into some combination later than the ninth. 

The case of indivisible, large-unit factors of the producible 
sort is, naturally enough, dififerent. We have some control of 
the situation in that, when constructing such instruments, we 
can adapt them to a particular output, — make them of the 
proper size to supply this output most cheaply. But, as a mat- 
ter of course, they will be called on to supply dififerent volumes 
of output at dififerent times. Naturally, the volume for which 
they will be planned will be that one which is expected to be 
normal. They will, therefore, be built on a scale which enables 
them to supply this normal output when working in the com- 
bination showing least cost.* It follows that, under normal 
conditions, such indivisible producible factors will be working 
in that particular combination lying between the ninth and the 
nineteenth which shows least cost. If, however, the demand 



* They will probably be built on a little larger scale than this in 
anticipation of increasing need. 



INCREASE IN OUTPUT: CONSEQUENCES 



123 



is abnormally large, they will be pushed into some later com- 
bination; while, on the other hand, if it is abnormally small, 
they will be brought back into some combination lying be- 
tween the least-cost one and the ninth, or, even, into one earlier 
than the ninth. 

5. The Diminishing Marginal Significance of 
Factors 

One more important fact which in part anyhow grows out 
of our effort to increase output by increasing the quantity of 
the auxiliary factor used, is suggested by the title of this sec- 
tion: "The Diminishing Marginal Significance of Factors." 
In general the different units of any particular kind of factor 
can be put to uses Jiaving different, degress of importance or 
significance. When such uses are wholly distinct, this pro- 
position is evident enough. Thus, in time of war, the food 
supplied to the soldiers in the field plays a more important 
role than that destined for the ordinary civilian ; and the steel 
used in making ammunition is more significant than that de- 
voted to making pleasure cars. Even if the different uses have 
to do with one product, the case is scarcely less plain. Thus, 
the steel used in the corn farmer's plow is more important 
than that used in his spring-toothed harrow ; without the for- 
mer he could scarcely farm at all, the latter he might dispense 
with rather easily. Finally, different uses of the same factor 
differ in importance or significance even when the factor is 
operating in just the same way. Thus, if, under similar con- 
ditions, a cultivator goes over a cornfield several times, the im- 
portance of the service it renders will be smaller as the number 
of times increases. This, manifestly, is merely a special ap- 
plication of the principle of diminishing marginal productivity 
brought out in the preceding chapter. 

But, not only may the different uses to which a given fac- 
tor is put vary greatly in importance or significance, among 
these different significances there is one which plays a much 
more important role than the rest. That one is the smallest 



124 PRINCIPLES OF ECONOMICS 

or least of them all. Thus, if we have steel enough so that 
we can afford to use it for both the plow and the spring-toothed 
harrow, the significance of the steel used in the harrow will 
play a more important part than will the significance of the 
steel used in the plow. The former rather than the latter will 
determine the estimate we put on the importance of the amount 
of steel necessary to make a plow or a harrow.* The reason 
is not far to seek. Our estimate of the importance of any- 
thing — in this case the quantity of steel necessary to make 
either a plow or a harrow — depends on how much loss we 
should experience if we had to give it up. But, if we had to 
give up either the plow or the harrow, the one chosen for the 
sacrifice would, of course, be the harrow, the less important 
of the two. The significance lost to us, therefore, would be the 
lesser significance ; and, hence, the estimate which we make of 
the importance of steel would be determined by the lesser 
significance. Broadening the statement so as to cover the 
whole stock of steel, we say that the estimate we make of 
the importance of steel would be determined by its significance 
in the least important use, — its least significance. 

This least significance of any factor which is of such im- 
portance in economics, we designate its marginal significance. 
The designation signifies that this particular significance is 
located at the boundary line separating the significances which 
are realised from those which are not. 

We have seen that the different significances of any factor 
are quite unequal, and that one of these, the marginal signifi- 
cance, is of great moment in economic matters. We must now 
add a proposition which we will call The Principle of Dimin- 
ishing Marginal Significance. 

Generally speaking, the marginal significance of any factor 
tends to diminish as the quantity of that factor available in- 
creases. 



* As we shall learn later, this estimate will have a part in de- 
termining the value or price of steel. 



INCREASE IN OUTPUT: CONSEQUENCES 125 

The marginal significance of a kind of land of which 
there are millions of acres available will be much smaller than 
it would be if there were only hundreds. As between differ- 
ent kinds of land, the marginal significance of the kind of 
which there are only hundreds of acres will very likely be 
greater than the marginal significance of a kind of which 
there are millions of acres, even though the generic signifi- 
cance of the latter kind is much greater. 

That things are bound to work in a way to make the 
above proposition true is easily seen. Assuming the gener- 
al rationality of business conduct, the uses to which any factor 
have not as yet been put will be less significant than those to 
which it has been put. It follows that, if new supplies of that 
factor are forthcoming, they can be utilized only by assigning 
them to uses which have less significance than those already 
provided for. Hence the principle. 



CHAPTER IX 

INCREASE IN OUTPUT AND COST OF 
PRODUCTION 

A very important topic closely connected with the one 
which has occupied the last two chapters is the effect on cost 
of production caused by attempts to increase the volume of 
output. This problem really breaks into two problems: (i) 
what will be the effect on cost of trying to increase output 
from a particular instrument or group of instruments fixed in 
amount, and (2) what will be the effect on cost of trying to 
increase the output from a particular industry as a whole, with 
no restriction on the quantity of any instrument or factor. We 
begin with the former of these problems. 

I. The Effect on Cost of Trying to Increase Output from a 

Particular Instrument or Set of Instruments 

Fixed in Amount 

Interpreted as asking: what will be the effect on cost of 
trying to increase output from a single instrument or set of 
instruments fixed in amount, our new problem is very close 
to that treated in Chapter VII. In fact, if we mean by cost 
only the expenditure for the factor which increases, the two 
problems are one, looked at from slightly different points of 
view. Under the conditions named, to say that a plant or a 
business is in the condition of diminishing returns would 
amount to the same thing as to say that it is in the condition 
of increasing cost. But, in the real world, all economic fac- 
tors have prices, Ns as well as Ls. The total cost, therefore, 
will not change merely with the change in output as measured 
in Ls; it is bound to be influenced by the changes in output 
as measured in Ns also. But, though different, the two prob- 



COST OP PRODUCTION 127 

lems are very closely connected ; and the solution of the one 
treated in Chapter VII plays a large part in the solution of 
the new one. 

Our first task is to consider the effect on cost of trying 
to increase output from simple combinations like those made 
up of our Ns and Ls. The solution is not difficult, though 
the explanation must be followed with some care. First, the 
cost per unit of product for any particular combination must 
equal the cost per unit measured in Ns plus the cost per unit 
measured in Ls. For example, if in a given combination the 
average output measured in Ns is 10 units and each N costs 
$1, so that the cost of each unit measured in Ns is $1 over 10 
or 10 cents, and, if that same output measured in Ls gives 20 
units per each L while each L costs $1, so that the cost of 
each unit of product measured in Ls is $1 over 20 or 5 cents, 
then, the total cost of each unit of product must be 10 cents 
plus 5 cents, or 15 cents. 

Secondly, the cost per unit measured in either Ns or Ls 
must increase as the average output measured in that fac- 
tor diminishes, and must diminish as the average measured in 
that factor increases. For example, if the average output in 
Ns increases from 10 to 20 units, when each N costs $1, then 
the cost per unit, measured in Ns, falls from 10 cents to 5 
cents. On the other hand, if the average measured in Ns di- 
minishes from 20 to 10, the cost of each N being $1, the aver- 
age cost measured in Ns, rises from 5 cents to 10 cents. 

Again, since the average measured in Ns is increasing 
from the second combination to the nineteenth, while that 
average diminishes from the twentieth on, the cost, measured 
in Ns, must decline from the second to the nineteenth com- 
bination and must increase from the twentieth on. On the 
other hand, since the average, measured in Ls, increases up to 
the ninth combination and then diminishes to the end, the 
cost, measured in Ls, must also diminish up to the ninth com- 
bination and thereafter increase to the end. Further, since 



128 PRINCIPLES OP ECONOMICS 

the decline in the average measured in Ls is slow during the 
first few combinations after the ninth, and increases rapidly as 
it approaches Combination 19, the cost in Ls rises slowly during 
the earlier combinations after the ninth and rapidly during the 
later ones. In like manner, the cost in Ns, though declining up 
to the nineteenth combination, does this rapidly only during 
the earlier combinations after 9, slowing up as it approaches 
the turning point at 19. 

The last two paragraphs have shown us the course followed 
by the cost of production as measured in one or the other 
of the factors taken separately. It is now easy to see how the 
total cost per unit, that is, the cost measured in both factors 
must behave. Since cost, measured in either factor, diminishes 
up to the ninth combination, the average of the total cost 
must diminish up to that same combination. Again, since the 
average cost measured in either factor, increases after the 
nineteenth, the average of the total cost must increase after 
the nineteenth. This statement disposes of the first and last 
eight combinations. What, now, is to be said with respect 
to the remaining eleven? First, in so far as the cost for 
any one of these is influenced by the cost measured in Ns, that 
cost will tend to diminish clear up to the nineteenth com- 
bination, since the cost measured in Ns is so diminishing. On 
the other hand, in so far as the average of the total cost is 
being influenced by the cost measured in Ls, it will tend to 
increase from the ninth combination on, since the cost meas- 
ured in Ls is so increasing. 

Further, as already noted, the upward pull on costs exer- 
cised by Ls is relatively small in the earlier combinations after 
9, but rapidly increases as they approach 19. So likewise, the 
downward pull of Ns is great in the earlier combinations 
after 9 but weakens as they approach Combination 19. 
From these facts it follows that the general trend of the total 
average is downward during the earlier combinations, upward 
during the later ones. But, since there must be a turning- 



COST OF PRODUCTION 129 

point between these two opposite trends, one or more* of 
the combinations must show a lower cost than the others, a 
least cost. In short, for any particular pair of prices for 
Ns and hs, we are bound to have results like this : ( i ) dur- 
ing a shorter or longer series of combinations, cost will de- 
cline; (2) then a least-cost combination** will appear; and 
(3) during a longer or shorter series, cost will increase. 

What, now, is to be said with respect to the location of 
the least-cost combination? In general, this must depend on 
the relative prices of Ns and Ls. As we have already seen, 
the influence of Ns must tend to lower cost with every move- 
ment toward Combination 19, while the influence of Ls must 
tend to increase the cost with every movement from 19 to- 
ward 9. It follows that the least-cost point will tend to move 
toward 19 under the influence of Ns and toward 9 under the 
influence of Ls. Which of these opposing forces will out- 
weigh the other depends upon their relative magnitude, that 
is, the relative magnitude of the prices which the producer 
has to pay for Ns and Ls. If Ns are very costly, this will 
tend to push the least-cost point toward the nineteenth com- 
bination, and vice versa. If, for example, Ns cost 20 cents 
each and Ls $1, the cheapest combination will be the eleventh; 
while if Ns cost $1 each and Ls 40 cents each, the seventeenth 
combination will be the cheapest. 

The foregoing discussion would seem to clear up pretty 
fully the problem of cost as affected by changes in combin- 
ing proportions. Before going on, however, we ought, per- 
haps, to contrast this problem of changing costs with that of 
changes in output as affected by changes in combining pro- 
portions. As we have seen, the principle that output tends 
to increase less than proportionally is the same as the prop- 
osition that cost tends to increase only on condition that we 
are measuring cost in the changing factor. This point, brought 
out more sharply now that we are clear as to the behavior of 

* Usually one. 

** Or pair of combinations. 



I30 PRINCIPLUS OP nCONOMlCS 

total cost, means that the turning-point from the preceding 
stage to the one under consideration occurs in a different 
comhination in the two cases. For example, in our series of 
supposed combinations, the output is increasing more than 
proportionally up to Combination 9, after which it increases 
as far as Combination 19 less than proportionally ; that is, for 
output, the ninth combination is the turning-point. As we 
have just seen, however, the turning-point for cost is prac- 
tically always a combination later than the ninth. If we sup- 
pose the price of each of the factors to be just $1, the turn- 
ing-point, the least-cost combination, proves to be Combina- 
tion 14. Further, as was fully explained, this turning-point 
varies with every considerable change in the relative prices of 
the two factors. In short, instead of being at the same com- 
bination as the one at which diminishing returns sets in, it 
almost never occupies this place, and it may theoretically be 
in any one of the 11 combinations from the ninth to the 
nineteenth, inclusive. This point needs some emphasis, be- 
cause not a few writers have carelessly identified the princi- 
ple that, after a certain point, the proportional returns di- 
minish, with the principle that, after a certain combination is 
reached, cost of production begins to increase. 

We may add, as an application of the distinction between 
these two principles that in any particular case of the utili- 
zation of a factor of production, we may have passed the 
point of diminishing returns and yet not have reached the 
point of increasing cost. For example, if our Ns represent 
a furnace used in the heating of a house, and if the combina- 
tion which gave out the largest amount of heat per unit of 
coal was the 13th, then if we are actually using the furnace 
in the nth, we should be using it in a stage earlier than the 
least-cost stage, but not earlier than the diminishing-retum 
stage. If, however, the day was very mild and we were 
using the furnace in the 7th Combination, we should be 
working it in a stage which was earlier than the diminishing- 
retum one as well as earlier than the least-cost one. 



COST OF PRODUCTION 131 

Ili^ustrative: PrOBIvI^M 

It is possible to be using a railroad plant in such a con- 
dition that, if we could increase the traffic a certain amount, 
we could increase the return per unit of the assisting fac- 
tors, and so diminish the cost. But we might also be work- 
ing that plant under such conditions that, though we could 
no longer increase the return per unit by increasing traffic, we 
could, after all, diminish the cost of production. 

Explain how this could be. 

At first thought it might seem that this precise locating 
of the least-cost combination would be of little practical im- 
portance on the ground that we would always take pains to 
be working in the least-cost combination. As a matter of fact, 
however, we would rather seldom be able to work our fac- 
tors in this combination. In almost all situations, we have a 
body of relatively fixed factors over against a set which are 
constantly changing in quantity. The former are collectively 
called the fixed capital, the others the circulating capital. From 
the standpoint of costs, the former are often called overhead 
costs, the latter prime costs or out-of-pocket costs. Now, 
in the nature of things, the former cannot be nicely ad- 
justed to every change in the volume of output. Any plant 
will naturally be planned and built on such a scale that, when 
supplying its normal output, it will be working in the least- 
cost combination.* But when a volume of output smaller 
or greater than this is temporarily called for, it will become 
necessary to work the plant in a combination earlier or later 
than the least-cost one. That is, it may be necessary and 
proper, much of the time, to be working a plant in the dimin- 
ishing-cost stage or the increasing-cost stage. 

* This statement needs qualification because of the fact that it will 
usually be thought best to plan for future growth of demand; so that 
the plant will more usually be built on such a scale that, for a time, 
it will normally be working in a stage somewhat earlier than the least- 
cost stage. 



132 



PRINCIPLES OP ECONOMICS 



What has been said of a plant can with equal truth be 
said of a business unit as a whole. Here, as before, the plant 
or group of plants run by the concern will sometimes be 
working in a stage earlier than the least-cost combination, or 
just at that combination, or later, — in the first case, being in 
the condition of diminishing cost, in the second and third 
cases being in the condition of increasing cost. In addition, 
similar statements may be true with respect to the organiza- 
tion side of the business unit or company. The force of gen- 
eral officers, and of departmental superintendents, may be 
working in some stage prior to that of least cost or subse- 
quent to that stage. 

Finally, it would seem that the propositions which have 
been laid down with respect to single instruments, plants, 
and business units, may be affirmed with respect to social 
groups, districts, countries, even the world. Broadly speak- 
ing, any one of these totalities may at any moment be in 
such a condition that an effort to increase the aggregate of 
economic goods in order to satisfy the needs of a larger 
population would result in a diminishing expenditure of 
human effort and natural resources, or just the reverse. In 
the former case, the community under consideration would 
not have carried the utilization of its outfit of natural resourc- 
es to the least-cost combination, though it might have car- 
ried that utilization beyond the point of diminishing returns. 
And an increase in population calling for a larger output of 
products and furnishing a larger supply of human produc- 
tive power would enable the community to carry the utiliza- 
tion of its natural resources into a less costly and so more 
desirable stage. If, however, the community had already 
reached or even passed beyond the least-cost stage, the in- 
crease in population could only result in" driving the industry- 
info, or further into, the stage of increasing cost, and so, from 
our present point of view, could only result in harm. 



COST OF PRODUCTION 133 

2. The Effect on Cost of Trying to Increase the Output from 
an Industry as a Whole, There Being No Restriction 
on the Quantity of Any Instrument Used. 

We now pass to the second phase of our problem : the ef- 
fect on cost of trying to increase the output from an indus- 
try as a whole. What will happen to cost, if we try to get 
more copper from the copper industry, or more wheat from 
the wheat industry, or more automobiles from the automobile 
industry? Will the cost per unit remain the same as before 
or become larger or smaller than before? This question, like 
our original one breaks into two. ( i ) What will be the imme- 
diate effect on cost in a given case? In other words, in what 
stage is an industry at this moment, diminishing cost, constant 
cost, or increasing cost? (2) What will normally be the effect 
in a given industry? What effect is characteristic of that 
industry? In which of the three stages is that industry likely 
to be most of the time? 

In order to answer these questions even briefly, we need to 
have in mind the principal causes which tend to affect the 
cost of production as output is increased. Of these there are 
three. The first cause to be considered is the condition of the 
instruments already being used in the industry in question. 
Are those instruments being worked in the stage of diminish- 
ing cost, or minimum cost, or increasing cost? Their condi- 
tion in this respect, in so far as they are able to influence the 
matter at all, will obviously tend to establish a like condition 
for the industry as a whole. A second cause affecting cost 
is the degree of difficulty experienced in duplicating the instru- 
ments employed in an industry. Will the new machines, the 
new labor, and the new land needed to expand output cost the 
same as, or more or less than, our present stock cost us ? The 
third cause is the degree to which the industry is able to real- 
ize the advantages of large-scale production set forth in an 
earlier chapter. The possibility of using large-scale methods 
must of course tend to put the industry into the condition of 



134 



PRINCIPLES OF ECONOMICS 



diminishing cost; and the extent to which these methods can 
be used must determine largely how potent they will prove. 

Now, when we are asking after the immediate condition 
of an industry, the potency of these three causes above enu- 
merated depends chiefly on two considerations : (a) the state 
of industry in general, and (b) the nature of the particular in- 
dustry involved. 

First, to begin with the former of these two considerations, 
any particular industry is likely to be in the condition of dimin- 
ishing cost when business is depressed, in that of increasing cost 
when business is booming, and in that of constant cost when 
business is in a state lying between these extremes. The rea- 
sons are evident.. The depression means that demand for 
products is small and prices low. In consequence, an attempt 
to increase output in response to increasing demand would 
find the situation advantageous in at least three ways. The 
fixed capital of the industry would be working in a condition 
of low efficiency or high cost, and the expansion of output 
would enable producers to utilize that fixed capital in a more 
efficient, less costly stage. Again, the low prices of a period 
of depression would make the factors necessary for expan- 
sion more than ordinarily cheap. Finally, the increase in out- 
put would open the way for a fuller utilization of large-scale 
methods. All this would obviously be reversed at the height 
of a boom. Fixed capital would be working beyond the point 
of highest efficiency; the cost of factors would be very high; 
the advantages of large-scale methods would already have 
been utilized to the full. Finally, in the period between these 
extremes, these opposing tendencies would come to some- 
thing like an equilibrium in which expansion of output 
brought neither less nor greater but the same cost. 

But, again, the working out of these tendencies would be 
influenced by the nature of the industry in question. The in- 
fluence of the possibility of getting more services out of 
fixed capital, of carrying that capital forward to the point of 
minimum cost, would signify little in the case of an indus- 



COST OF PRODUCTION 135 

try which used little of this type of capital, — say retail trade — 
but much in an industry such as mines and steel mills, which 
used a great deal. Similar differences would show in the in- 
fluence exerted by the cost of the factors necessary to expan- 
sion. The industries utilizing a large amount of fixed capi- 
tal and a relatively small amount of new factors would nat- 
urally be less affected by the increase in cost of the latter. 
The smaller the out-of-pocket expenses, the smaller the sig- 
nificance of this element. Thus, farming is not affected as 
favorably as many other lines of industry by the low prices 
of supplies prevailing in a period of depression nor as un- 
favorably by the high prices of those supplies characteristic 
of the top of a boom. Finally, the power to utilize the advan- 
tages of large scale production varies greatly in different in- 
dustries. In farming, for example, the power is proverbially 
low. The necessary operations are very diversified and there 
is little repetition of operations which duplicate one another; 
the fundamental factor in this industry, the land, is also di- 
verse in character, one part of a farm being fit for one pur- 
pose and another fit for another purpose ; and, finally, the 
necessity for rotation of crops compels frequent changes in 
methods and output. All these causes, taken together, make 
high specialization in agriculture imprudent where it is not 
impossible. Accordingly this industry and others of a similar 
kind are less influenced in respect to costs by the general busi- 
ness situation. Their variation in cost as output expands is 
less considerable than in the other cases. 

The foregoing discussion has in a large measure antici- 
pated what we need to say concerning our second question : 
what is the normal tendency of cost in a particular industry 
as output is expanded, or what tendency is characteristic of 
that industry? The answer manifestly has little relation to 
temporary business conditions, being almost entirely a matter 
of the nature of the business itself. 

Here the first cause — the condition of the instruments al- 
ready being used in the industry — though relatively unimpor- 



136 PRINCIPLES OP ECONOMICS 

tant, is not without some influence. An industry which nec- 
essarily employs a very large amount of fixed capital will al- 
most always have a considerable quantity of unused utilities 
tied up in it. The expansion of output will enable such an 
industry to utilize these tied-up services more completely and, 
to that extent, enable it to lower costs. It follows that such 
an industry is more likely than others, during much of the 
expanding period, and without respect to the state of industry 
in general, to be in a condition of diminishing cost. 

As respects the influence of the difficulty experienced in 
duplicating instruments, this is naturally greatest in industries 
largely dependent upon natural factors. The extractive and 
agricultural industries, therefore, under the influence of this 
cause, are much more likely to be in the condition of increasing 
cost than manufactures or commerce. The narrower the field 
from which the natural factors can be drawn, the greater force 
will this cause exert. It will be felt much more in the pro- 
ducing of citrous fruit than in the producing of wheat and 
potatoes; more in platinum mining than in copper mining; 
more in copper mining than in iron mining. Finally, as to 
the influence of the third cause, an industry that consists large- 
ly of many similar or identical operations, and can therefore 
apply methods of large-scale production, will tend to be in a 
condition of constant cost, or even of diminishing cost. Man- 
ufactures are conspicuously of this type, and agriculture con- 
spicuously not. 

Looking back over this discussion, we see that all the dif- 
ferent causes combine to hinder manufacturing from being 
in the condition of increasing cost, and to keep it in a con- 
dition of constant or diminishing cost. The manufacturing 
plant ordinarily has a large store of unused utilities; it de- 
pends relatively little on natural resources; and it is well 
adapted for the employment of large-scale methods. On the 
other hand, agriculture tends just as strongly, under the in- 
fluence of all these causes, to be in a condition of increasing 
cost. It will seldom have any great volume of unused utili- 



COST OP PRODUCTION 



137 



ties to put it into the condition of diminishing cost; the nat- 
ural factors play a large part in its operation ; and the chance 
of employing large scale methods is very slight. In the min- 
ing or extractive industries the result is much the same al- 
though the operation of the different causes is a little differ- 
ent. The mining industries make extensive use of fixed cap- 
ital, hoisting machinery, machinery for crushing the rocks, fa- 
cilities for transportation, etc. On this score we might be led 
to think of these industries as diminishing cost industries or 
even constant cost. And in fact when a new grade of mine 
has become available by a rise in price the industry is likely 
to be temporarily in the condition of constant cost. That is, 
it will be possible for a time to expand output far beyond 
the expansion of demand without any new increase in cost. 
This particular element mining has in common with manufac- 
ture. But the former industry naturally gravitates in general 
into a class with agriculture because of the influence of the 
second cause which we originally named. That is, the de- 
pendence upon natural factors is so great that the relative dif- 
ficulty of obtaining these factors in the productive process off- 
sets the advantage derived from the former element. 

Summarizing the chief results of the preceding discus- 
sion we may set forth the following propositions : 

(i) Any industry may be at some time or other in each 
one of the three stages : diminishing cost, constant cost, and 
increasing cost. 

(2) Most industries are likely to be in the condition of 
diminishing cost if the demand for their product is so small 
that an increase in that demand would enable the industry to 
pass from small scale to large scale methods. 

(3) Most industries may be for considerable periods in the 
condition of constant cost whether their general classification 
is in diminishing cost or increasing cost, because of the fact 
that at any particular level of cost there is possible an in- 
crease in output which is very large as compared with the ex- 
pansion of demand. 



138 PRINCIPLES OP ECONOMICS 

(4) Practically all industries must some time reach the 
stage of increasing cost. 

(5) In general the agricultural and extractive industries 
naturally class as increasing-cost industries. 

(6) In general manufacturing industries classify as con- 
stant-cost industries. 

I1.1.USTRATIV1; Problems 

1. "Taken by large, the mining of copper is probably an 
increasing-cost industry." Defend that statement. 

2. Argue for the reasonableness of the proposition that, 
if the marginal cost of producing copper should rise from, 
say, 20 to 25 cents per pound, at the latter figure this indus- 
try would probably be for a time a constant cost industry. 

3. Give some reasons for believing that railway trans- 
portation is likely to be much of the time in the condition of 
diminishing cost (increasing returns). 

4. An industry like the making of surgical instruments is 
likely to be in what condition as respects the relation between 
cost and volume of output? Explain. 

5. Suppose that, while competition in the industry is still 
maintained, the conditions of production for a particular type 
of wooden chair are such that, if fewer than 1,000 chairs a 
year are produced, the cost per chair will be about $3 ; that, 
if output is between 1,000 and 20,000, cost will be about $2; 
that if it is between 20,000 and 50,000, cost will be $1 ; if be- 
tween 50,000 and 500,000, 50 cents ; if between 500,000 and 
2 millions, 30 cents ; if between 2 millions and 3 millions, 40 
cents ; if between 3 and 4 millions, 55 cents ; if between 4 and 
5 millions, 75 cents; if between 5 and 6 millions, $1.25; and 
so on. 

(a) Suppose that in the year 1918, 700,000 of these chairs 
are produced; that by 1920 the output has increased to 1,300,- 
000; that by 1925 the amount is 1,600,000; and that by 1940 
it is 1,800,000. To what class of goods would these chairs be- 
long during the period of 1918 to 1940, looked at as a whole? 

(b) Suppose that between 1950 and 2000 the output 
should increase from 2,300,000 to 6 millions. To what class 



COST OF PRODUCTION 139 

of goods would these chairs belong during that 50 years, looked 
at as a whole? 

6. During the great boom in the prices of farm products 
characteristic of the war period, farmers who heard com- 
ments by other classes on the point were wont to say: "But 
look what prices we have to pay for all sorts of supplies, seed, 
fertilizer, binding twine, labor, etc. This increase in costs 
makes big prices necessary." Criticise that reasoning. 



CHAPTER X 

MONEY EXCHANGE 

With the present chapter we enter upon the study of that 
topic which forms the most important part of Economics, 
namely, Exchange. The starting point of this study is found 
in facts that have already been made familiar by the earlier 
chapters. First, we are creatures having many wants de- 
pendent for their satisfaction on our power to utilize certain 
material objects or conditions, called economic goods. Sec- 
ondly, these goods are not as a rule supplied to us free from 
the hand of nature; rather they must be produced, created 
out of nature's materials by the application of human effort. 
Again, the method of supplying ourselves with economic 
goods which proves most advantageous is not for each to pro- 
duce all the different kinds he wants, but rather to produce 
some one kind, whether a finished commodity or only a con- 
tributory service, and use this to get from his neighbors 
through exchange the other goods which he needs. Thus 
exchange is the very central, pivotal, fact in our whole eco- 
nomic order; every other fact and circumstance is directly or 
indirectly affected by it ; and every aspect of the exchange 
phenomenon may therefore be expected to repay the most 
careful inquiry. 

The first phase of the subject to be considered is a pure- 
ly technical one, namely, the mediating of exchange, the ef- 
fecting of exchange through a middle term. From this stand- 
point we distinguish two principal exchange processes : ( i ) 
Money Exchange and (2) Credit Exchange. In the present 
chapter we take up the former. 



MONEY EXCHANGU 141 

Section A. The Nature of Money Exchange 

Although the facts of money exchange are familiar 
enough to every one, their essential nature and the causes ly- 
ing back of them demand a moment's examination. The be- 
ginnings of exchange, as found in primitive societies, have al- 
ways taken the form of barter — the direct exchanging of 
goods for goods. A man who has grain to spare and wants 
a canoe, gets into communication with a neighbor who has 
canoes to spare and wants grain, and a mutual transfer is ef- 
fected. But this method, even in the most favoring condi- 
tions, is highly inconvenient. The man who has produced a 
surplus of grain which he wishes to exchange for a canoe is 
obliged first to seek out someone who has a canoe to dispose 
of and at the same time needs grain and who, further, needs 
grain in an amount exactly corresponding to the value of the 
canoe. 

But this necessary coincidence between exchangers as re- 
spects the kinds and amounts of goods wanted and offered 
can exist but rarely, and, where it does exist, can be discov- 
ered only after laborious searching. It would not be hard to 
find men who want grain ; but they may have no canoes to 
dispose of. So it would be fairly easy to find men who have 
canoes to sell; but they may not want grain; or, if any one of 
them does want grain, he may want only half as much as 
would be needed to pay for a canoe. As civilization advances 
these obstacles to barter become more and more serious. Oc- 
cupations, tastes, and incomes grow more diverse, and a larg- 
er and larger number of workers produce things which, be- 
ing unfitted to satisfy their own wants, must be exchanged, 
but which at the same time are wanted by only a few other 
individuals, and those perhaps widely scattered. For such 
persons — that is, for most of us — exchanging their own prod- 
ucts directly for all the different kinds of goods they require 
would be entirely out of the question. For a manufacturer of 



142 PRINCIPLES OF ECONOMICS 

steel rails or mowing machines or microscopes or surgical 
implements to go about trying to obtain, in trade for these 
wares, sugar or flour or a suit of clothes, would be not mere- 
ly inconvenient but futile. 

But no highly developed society tries, or ever did try for 
long, to conduct its exchange on the barter plan. In the ear- 
liest trade of which we have any record, men were already 
making use of a medium of exchange — some go-between 
which each one sought to get in exchange for his goods and, 
having gotten, used to buy other goods. ' The exchange me- 
dium consists of some concrete good of such a nature that 
everyone will be willing to accept or to relinquish it in pay- 
ment for other commodities ; and of such a nature that it can 
readily be divided or enlarged to make up an amount exactly 
equal in value to any object which is offered against it. With 
the assistance of such medium, the troubles of the man vv^ho 
has grain to dispose of and wants a canoe quickly disappear. 
He simply sells his grain to the different persons who want 
grain, they giving him from their easily divisible store exactly 
as much of the exchange medium as the grain is worth ; and 
then, taking to a canoe maker the medium thus obtained, he 
pays over as much of it as is necessary to purchase a canoe. 

Exchange, then, is mediated by money, and wherever the 
money institution exists its principal function is to serve as 
the medium of exchange. It perhaps ought to be remarked 
in passing, however, that just because money is the medium 
of exchange, it almost inevitably takes on other functions. It 
serves, for one thing, as a measure of value. Being exchanged 
against all other goods, it naturally becomes the thing in 
which the values of all other goods are computed and ex- 
pressed. It sometimes performs this function even when not 
actually called upon to serve as the middle term in exchange, 
as for example when two people estimate the value of their 
respective goods in terms of money, and yet proceed to ex- 
change them directly, barter fashion. In fact, the value-meas- 



MONEY EXCHANGE 



143 



tiring function of money often exists quite independently of 
its exchange function, and often seems of almost equal impor- 
tance. Again, money or its equivalent, bank credit (which 
comes up for treatment in the next chapter) serves as a me- 
dium of accumulation, the instrument through which accu- 
mulations of capital are immediately effected. Closely allied 
to this last is the service as loan medium since, as we know, 
the man who borrows capital must usually obtain it first in 
the form of money or bank credit. Money is also utilized as 
the legal means of payment, in the discharge of taxes, fines, 
etc. Finally, in backward countries it is much employed, 
along with precious stones, as a storer of wealth by men who, 
seeking to save their property from robbers or tyrannical 
governments, turn it into these easily concealed forms. Vari- 
ous other functions of money could doubtless be distinguished 
in a fuller analysis. The central one, however, the one with 
which we are chiefly concerned in this course, and hence 
the only one calling for more than passing mention, is to serve 
as a medium of exchange. 

In the earlier forms of exchanging society, the exchange 
medium or go-between was always some use-commodity, that 
is, a commodity which people generally wanted for some pur- 
pose to which it could be put directly, as for example, cat- 
tle, hides, tobacco, lumps of salt, or cubes of tea. But, with 
the passage of time and the increase of wealth, people got in 
the way of using as their medium of exchange something spe- 
cially manufactured and set apart for this function. It is 
only when this stage is reached that we can properly talk 
about money ; for by money, we mean an instrument specially 
made for and adapted to the work of mediating exchange, 
and to those other tasks naturally performed by the exchange 
medium. 

For many centuries after its introduction, the money of 
even the most advanced countries was little more than an 
aggregation of rather crude coins of very few varieties or 



144 PRINCIPLBS OP ECONOMICS 

sizes. But with the progress of industrial society, the money 
of each country has come to constitute an elaborate system 
containing many different kinds of money adapted to the per- 
formance of different functions, and all more or less perfectly 
co-ordinated into a coherent, self-consistent whole. We must 
now explain the principal features of such a system. 

Section B. The Monetary System 

I. The Denomination System 

The first element to be remarked in the American or any 
other monetary system is the scale of denominations, the 
names employed for expressing quantities of money. The need 
for some means of doing this is easily seen. Since money is 
the common thing which exchanges against all other goods 
and since these goods range in value from almost nothing to 
millions of dollars, it is necessary that we should be able to 
make up sums of money from the highest to the lowest. Hence 
the stock of money is divided into coins or hills of various 
sizes. But we must be able also to describe or express the 
sums made up ; and for this reason, each kind of money has 
a name of its own, and has a well recognized quantitative re- 
lation to each of the other kinds. Or, rather, one kind is taken 
as a unit, and all the others stand in a recognized quantitative 
relation to this one. 

Money denominations may thus be distinguished as Pri- 
mary and Secondary. The primary denomination, more oft- 
en called the monetary unit, is fundamental in the system, the 
other denominations being referred to it in defining their 
quantity. The precise significance of this statement is best ex- 
plained by comparison with an analogous case, the unit of li- 
quid measure. The gallon constitutes this unit, and other 
quantities are described as fractions or multiples of a gallon: 
thus a quart is a fourth of a gallon and a pint one-eighth of a 
gallon; thirty-one and one-half gallons make one barrel, and 



MONEY EXCHANGE 



145 



sixty-three gallons (two barrels) make one hogshead. Simi- 
larly, in the American monetary system the unit is one dol- 
lar, and all secondary denominations are regarded as fraction- 
, al parts or multiples of the dollar. The cent is one one-hun- 
dreth of a dollar, the dime a tenth of a dollar, the twenty-five 
cent piece a quarter of a dollar, the half-eagle ten dollars, and 
the eagle twenty dollars. In other countries, these denom- 
inations are different from the American and usually from 
: those of any other nation. But in all of them some kind of 
i a denomination system exists, in that one quantity of money 
/ is established as the unit of measurement, and all others are 
defined in terms of that unit. 

2. The Monetary Standard 

The second essential element in a monetary system is the 
monetary standard. The special ofiice of the standard is to 
fix the meaning or value of the monetary unit. For purposes 
of explanation, let us again refer to the analogue of liquid 
measure. As we all know, there exist at the present time 
thousands of liquid containers called a "gallon." But, due to 
various circumstances, they are not exactly equal in their ca- 
pacity. Now, if the various containers were allowed to differ 
even slightly in capacity, while all were known as gallon con- 
tainers, the significance of the quantity called a gallon would 
change every time a new container was used, and the way 
would be opened for an infinite amount of error or cheating. 
How, then, is uniformity to be attained? How bring it about 
that the gallon shall always signify one thing? Simply by re- 
quiring that a true gallon measure shall be able to hold a cer- 
tain amount, by weight, of some one substance, no more and 
no less. The standard chosen is pure water under prescribed 
conditions of temperature and air pressure. The amount is 
8.33 pounds. This fact we express by saying that 8.33 pounds 
of pure water is the standard of liquid measure in the Unit- 
ed States. If any receptacle proves upon examination to hold 



146 PRINCIPLBS OF ECONOMICS 

more or less than this standard amount, it is not a true gal- 
lon, and to make it so one must measure it something less than 
full, or full and something over. Only by being equal to the 
standard gallon can it hope to pass as a true gallon container. 
The monetary system is in this respect the same as that of 
liquid measure. The money unit is one dollar. But we have 
many different pieces of money which are represented as one 
dollar — a gold, a silver, a greenback and a bank note piece, as 
well as two fifty cent pieces, a hundred pennies, and so on. 
Now, all these so-called dollar pieces have very different de- 
grees of intrinsic value; the gold dollar is worth just as much 
whether it is coined or melted into a shapeless lump ; the sil- 
ver piece is worth as much as gold when coined, but very 
much less when melted ; the paper in itself is worth prac- 
tically nothing. Now, if these various pieces were allowed lo 
dii^fer even slightly in value while they were still known as 
dollar pieces, the significance of the dollar would change with 
every change in the kind of money used, and any accurate 
reckoning or dependable business agreements would become 
impossible. But uniformity is established here also by means 
of a standard. Within the boundaries of the United States, 
in every conceivable connection unless otherwise specified, one 
dollar means the amount of value which attaches to 25.8 grains 
of gold, nine-tenths fine. This amount of gold is known as 
the monetary standard, and against it every so-called dollar 
piece of actual money is judged. A true dollar must contain 
the same value as a piece of gold nine-tenths fine, weighing 
25.8 grains. And if any so-called dollar happens at any time 
to contain more or less than this standard amount of value, it 
is not a true dollar, and to make it so, something must be taken 
away or something added. 



MONEY EXCHANGE 147 

3. The Different Kinds of Money and Their 
Functions 

We have explained the denomination system and the 
standard essential to any monetary system. We must now 
distinguish the different kinds of money in which the denom- 
inations and the standard are embodied and comment on their 
several functions. 

First, we have the standard money, that particular kind of 
money which immediately em^hodies or represents the mone- 
tary standard. As already noted, the standard in the United 
States is 25.8 grains of the metal gold, nine-tenths fine. But 
we do not, of course, actually make any use in ordinary com- 
mercial relations of the mere metal gold, unmanufactured, in 
the form of dust or lumps. Neither do we have such a lump 
of gold locked up at Washington to act as a standard for our 
money unit, as we have a platinum-iridium bar locked up in 
that city to act as a standard for units of length. The plan we 
actually adopt is to issue one particular kind of money called 
standard money, which is kept equal in value to the real stand- 
ard, and, just as far as possible, to keep the meaning or value 
of the dollar in every other kind of money, (as well as in all 
credit documents, prices, etc.), the same as the value of this 
standard money dollar. In the American system, the stand- 
ard money is a coin made of the standard substance, gold, and 
containing just the amount of that standard substance which 
constitutes the standard. By devices which will more nat- 
urally be explained in a later connection, this kind of coin is 
all the time kept equal in value to the quantity of gold bullion 
which it is presumed to contain ; so that it may be said to em- 
body the real standard supposed to lie behind it. 

If, as just observed, the value of the dollar in other kinds 
of money, in credit documents, prices, etc., is kept equal to 
the value of the standard dollar, this means that the dollar 
in these other relations is not directly kept equal to the value 
of a lump of gold weighing 25.8 grains. It is kept equal to the 



148 PRINCIPLBS OP ECONOMICS 

value of the standard money, gold coin; and the latter, in its 
turn, is kept equal in value to the lump of gold. If by any 
process the gold coin and the lump of gold should be separat- 
ed in value, the dollar in other moneys, in prices, etc., would 
follow the gold coin rather than the bullion. This compels us 
to notice the distinction between the immediate monetary 
standard, the standard money, and the standard behind that, 
known as the ultimate standard, which consists of a lump of 
metal. 

In the American system, as just indicated, the standard 
money, being made of the same metal and the same amount of 
metal as that contained in the ultimate standard, may be said 
to embody the ultimate standard. This is also the plan fol- 
lowed in most good monetary systems. It should be noted, 
however, that such an arrangement is not absolutely neces- 
sary ; and we may better understand the relation between 
standard money and the ultimate standard by observing a 
quite different way in which substantially the same end could 
be accomplished. It is perfectly possible, theoretically, to have 
a system in which standard money is made of some other sub- 
stance than the one which holds the place of ultimate stand- 
ard. Thus we might issue a paper money which, by one de- 
vice or another, would be kept constantly equal in value to 
25.8 grains of gold, while the dollar in all other forms was 
kept equal to that particular kind of paper money. In such 
a system, 25.8 grains of gold would be the ultimate standard,, 
though standard money was paper money. 

The plan of having a standard money which does not em- 
body the ultimate standard; but is kept at par by some special 
device, suggests various schemes, which have been favored 
from time to time, for improving the ultimate standard. Thus,, 
some economists believe that, instead of having a single sub- 
stance as the standard, we ought to use a large number, say 
100 or more, in order to avoid too great and rapid changes in 
the value of the standard. A natural way to work out such a. 



MONEY nXCHANGB 



149 



plan would be to issue paper money as the standard money, 
and set up devices for keeping this paper money equal in value 
to the list of goods chosen. Another way would be to have 
for our standard money a coined money, as at present, but to 
redeem that money in varying amounts of gold, always larger 
than the amount in it, and always so adjusted as to keep the 
value of the coin equal to that of the list of goods originally 
chosen as the standard. 

Leaving this study of the nature of standard money, we 
must now add a word with respect to its functions. The stand- 
ard money of our system, gold coin, though to a limited ex- 
tent used as a medium of exchange in ordinary trade, is chief- 
ly confined to two offices: (i) serving as the money of inter- 
national trade, and (2) maintaining the gold standard by 
maintaining the convertibility of other forms of money. Stand- 
ard money serves best as the money of international trade be- 
cause it has a bullion or substance value as great as its nomi- 
nal value, whereas other moneys do not. A man who accepts 
it, therefore, need have no misgivings lest he get less than he 
bargained for. To a limited extent international dealers of- 
fer and accept non-standard moneys and, as we shall see in 
the next chapter, credit. But, in general, they must be paid 
in cash; and that cash must be something which is worth its 
face value. Hence they demand standard coin, or, even bet- 
ter, bullion or bar gold which has not been manufactured into 
money at all. 

But, while gold or standard money is needed for interna- 
tional trade, in the domestic exchange of most countries it is 
very little used. The chief function of gold money within a 
country is to maintain the convertibility into gold of other 
kinds of money and so to maintain the standard of the sys- 
tem. The standard, we know, has as its function the deter- 
mining of the meaning or value of the monetary unit in all 
kinds of money. But most kinds of money, other than gold, 
for example, silver coin, copper coin, bank notes, etc., have in 



I50 PRINCIPLBS OF ECONOMICS 

themselves as substance much less value than they claim on 
their face. A silver dollar, as silver, was, until quite recently, 
worth less than fifty cents; a hundred copper cents are rarely 
worth more than fifteen cents ; a paper dollar, as substance, has 
no appreciable value. It naturally follows that some effort is 
needed to keep these different forms of money at par with, 
or equal in value to standard money. There are various ways 
of accomplishing this result, but none really certain except one 
which makes it possible to get gold money in exchange for 
any other kind. It is not necessary that we be able to exchange 
other moneys for gold in any and every case, but it is necessary 
that we be able to obtain gold when we really need it, — for ex- 
ample, to make payments in other countries, — and that without 
being obliged to pay a premium or suffer inconvenience or de- 
lay. If at any time when we greatly needed gold we could not 
obtain a dollar of it for a dollar of other moneys, those other 
moneys would inevitably cease to be equal in value to the 
standard money. 

In concluding this treatment of standard money, a word 
should be added concerning a form of paper money which is 
virtually equivalent to gold coin. I mean the gold certifi- 
cate. This is a document certifying that the quantity of gold 
mentioned on its face has been deposited in the Federal Treas- 
ury, and is held ready to be delivered in exchange for the cer- 
tificate. The certificate is thus nothing more than a ware- 
house receipt for the gold coin in deposit. As long as the 
owner only wishes to hold this coin as a reserve or to use it in 
settlements at the clearing house, the certificate is all he needs, 
and is safer and easier to keep and carry about. And when a 
time comes that he really must have his gold for use in inter- 
national settlements, he can always get it by presenting the 
certificate. 

We have explained the nature and functions of a standard 
money, basic money, as it is sometimes called. We must now 
comment briefly on the other kinds generally present in the 



MONBY EXCHANGE 



151 



systems of our time. First, it is not uncommon to have a 
quasi-standard money consisting of a note issued by the gov- 
ernment or some special institution, a note which is legal ten- 
der in most or all relations, and redeemable in standard mon- 
ey. Such a money will perform most of the functions of 
standard money. Being directly redeemable in gold, every one 
will receive it readily, and only those who for some reason re- 
quire the metal itself will insist on using the treasury note to 
get gold. Moneys of this sort, though not seldom employed in 
everyday circulation, have as a more distinctive characteristic 
the fact that they in large measure constitute the bank reserves 
of the country, particularly the central reserves. Doubtless, 
these reserves ought to contain a considerable quantity of gold 
itself ; but the treasury notes answer almost equally well so 
long as the treasury keeps ample gold reserves to redeem 
them. 

The remaining moneys to be found in any system with 
which we are familiar are to be used mostly as ordinary media 
of exchange. First come the notes of the National banks pay- 
able at the issuing bank and also at the Federal treasury, and 
having the status of legal tender to all national banks. Next 
come the new notes issued by the Regional Reserve banks. 
These notes are hybrids somewhat difficult to describe. In 
form they are treasury notes, that is, they are promises to pay, 
signed by the treasurer. But the Regional banks are required 
to assume the responsibility for them as if their own officers 
had made the signature. These notes are a full legal ten- 
der, and are fit for bank reserves as also for circulation. 

A third sort of paper money is the silver certificate, which, 
in form, is a warehouse receipt for a corresponding amount of 
silver dollars, but which, in practice, is a bill used for what 
has been called "large change." It constitutes the major part 
of our everyday medium of exchange. It is exchangeable only 
for silver dollars, but it is worth its face value in gold just 
as if it were redeemable in that metal. 



152 PRINCIPLES OP ECONOMICS 

The remaining moneys of the country consist of various 
sorts of coin. In general, they are literally or virtually sub- 
sidiary coins, though, in strict usage, this designation is lim- 
ited to fractional silver. We therefore begin with explaining 
the distinctive characteristics of subsidiary coins. First, these 
coins are put out in small denominations, being specially in- 
tended for serving as a medium of exchange in minor trans- 
actions and as tools for "making change." Again, they are 
made of inferior metal, metal having low specific value ; for a 
coin of small denomination, if made of valuable metal, would 
be too small for convenience in handling. Subsidiary coins 
are characterized also by shortness in weight : they contain a 
smaller amount of metal than would seem to be called for by 
their nominal value. As a result, they are worth less as mere 
pieces of metal than as money ; so that, unless the value of the 
metal changes greatly no one will melt them for the sake of 
the metal they contain. Their circulation is thus assured. 

Again, subsidiary coins are strictly limited in the amount 
coined. They are issued only by the government, and the is- 
sue is limited to the amount which experience shows is really 
needed for the purpose of trade. This policy is primarily in- 
tended to insure the coins of this sort against falling in value 
below their nominal value ; and it has practically always been 
successful. So long as the needs of business keep subsidiary 
coins employed, so that few, if any, persons find themselves 
loaded up with an excessive stock, the coins remain at par. In 
the United States, this result is still more fully assured by a 
provision that the United States treasury will redeem such 
coins at par in legal money. 

Still another characteristic of subsidiary coin is the limita- 
tion of its legal tender prerogatives. This provision has two 
objects. First, it is intended to hinder any person from bur- 
dening creditors to whom he is making payment with a great 
quantity of inconveniently heavy coins. Second, it is intended 
to hinder subsidiary coins from displacing the standard money 



MONEY BX CHANGE 



153 



already established and putting themselves in its place, — a 
thing which might happen, if these coins were to become less 
valuable than standard money while still a full legal tender. 
How this would be brought about will be better understood 
when we have studied the principles governing the monetary 
standard given in Chapter XXII. 

A final characteristic of subsidiary money, not universal, 
but present under our system, is redeemability. The purpose 
of this provision — to insure that the money shall be kept at 
par — has already been explained, and needs no further com- 
ment. 

The last few paragraphs have dealt with the sort of coin 
which is universally recognized as "subsidiary." A word or 
two should now be devoted to the varieties not always, or per- 
haps usually, counted in this class. First, we have token 
money or billion, consisting of very small coins made of cheap 
metals, for example, our nickel five-cent pieces and copper 
cents. This type of money was evolved earlier than the coins 
usually designated as subsidiary. But, theoretically, there is 
no good ground for distinguishing them from the latter; they 
usually have all the characteristics above enumerated for sub- 
sidiary coins proper. 

The other money which is virtually, though not literally, a 
subsidiary coin is the silver dollar already alluded to on page 
151. This cannot be strictly described as a subsidiary coin, 
because it lacks the characteristic of limited legal tender which 
is present in true subsidiary coins everywhere, and also lacks 
the redeemability of American subsidiary coins. In effect, 
however, it is a subsidiary coin. It has most of the charac- 
teristics, and behaves as if it had them all. Although not lim- 
ited, as are true subsidiary coins, in legal tender prerogatives, 
it does not displace the standard. And although not redeem- 
able, it remains at par in spite of the fact that its metal value 
is much below its face value. These facts, however, should 
not lead us to think that the silver-dollar situation is an en- 



154 PRINCIPLES OF ECONOMICS 

tirely satisfactory one. On the contrary, most specialists are 
convinced that the silver dollar ought either to be withdrawn 
altogether, or frankly and completely given the status of sub- 
sidiary coins. 

IivLUSTRATivE Problems 

I. Illustrate with concrete examples the drawbacks of 
barter as a method of exchange. 

2. Illustrate the use of money as a measure of value in a 
case of barter. 

3. In primitive communities the media of exchange have 
usually been objects desired for direct use and also objects 
commonly produced in the community. Give some reason or 
reasons for each of these facts. 

4. During the first part of our history as a nation, silver 
fractional coins had the prerogatives of standard money, i. e., 
were freely coined and had the status of full legal tender. But 
in 1853 Congress deemed it necessary to put this kind of money 
into the position of subsidiary coin. How do you explain the 
fact that Congress got around to this opinion at about that 
particular time? 

5. Between 1890 and 1896 it was a common practice to 
put into notes and mortgages a clause providing for payment 
in gold coin of legal weight and fineness. Try to get the prop- 
er explanation of this fact. 

6. When I say that 12.9 grains of gold .9 fine is the mone- 
tary standard of the Philippines, what is meant? 

7. In the United States in the year 1868, when gold pay- 
ments on treasury notes were suspended so that a gold dollar 
was commonly worth from $1.20 to $1.40, one of the great 
political parties proposed to pay the national debt in these ir- 
redeemable treasury notes, — which proposal, however, was de- 
feated in the Federal election of that year. In discussing the 
matter, writers commonly speak as if the national creditors 
objected to being paid in treasury notes rather than gold; 
whereas no one of them probably would have thought of ask- 
ing for literal gold money. Explain in scientific language what 
was the precise issue of the controversy. 



CHAPTER XI 

CREDIT EXCHANGE 
Section A. The Process of Credit Exchange 

We showed in the last chapter why exchange was not and 
could not be to any great extent conducted on the barter plan, 
and why a mechanism of exchange had been built up, consist- 
ing of specialized processes and instruments or media. We 
have thus far discussed one of the processes — money exchange 
— and one set of instruments, — money. We now pass to a 
second process called Credit Exchange, and the set of instru- 
ments employed by it, called Credit. 

Money exchange, as we saw, is superior to barter chiefly 
from the fact that it uses a single standardized medium which 
every one is willing to accept. But it is easily possible to over- 
state the convenience and facility of trade resulting from the 
use of this device. Every one is willing to accept money, we 
say; but as a matter of fact, if a man sells a thousand or ten 
thousand dollars' worth of wheat or meat or land, he usually 
is very far from willing to accept actual money in exchange. 
In former ages, when actual possession of the money metal 
was prized as a sign of distinction, possibly most individuals 
received without hesitation practically all the money they could 
get. But this is not so today. No man however fond of 
wealth desires to have a bushel of money dumped on his 
floor. The heap would add little to his distinction, and would 
greatly embarrass him. 

But the use of money may be inconvenient for other rea- 
sons also. It is unlikely that any would-be purchaser will 
have a bushel of money to give. Because of the difficulty of 
guarding it, and because of its entire uselessness when not in 
active circulation, even the richest men prefer to keep in their 



156 PRINCIPLBS OP ECONOMICS 

possession at any one time only a small quantity sufficient to 
supply their every-day wants. When one requires a large lump 
sum, then, how shall he obtain it? Wait till it gradually accu- 
mulates, hoarding it as it comes in ; scurry here and there, sell- 
ing a little something to this man and a little something to that 
till he gets together a sum sufficient for his purchase? Fur- 
thermore, if he buys at a distance, at the extreme end of the 
continent or beyond an ocean, must the purchaser undertake 
the toil and expense and danger of transporting the money 
and delivering it into the seller's hands ? By no means. These 
difficulties are obviated by the use of a still more highly de- 
veloped medium of exchange, called Credit. 

Credit exchange is in its essence an exchange of goods not 
for money but for a promise to pay money. It is trade based 
on agreement, unaided by any concrete medium of exchange 
except such as may consist of writing on a piece of paper. 
Credit is a promise to pay money, and if the promise is trust- 
worthy, the creditor will not demand immediate delivery of 
the money itself. On the contrary, since he may before long 
be purchasing, from the debtor, goods for which he cannot 
conveniently deliver cash, he will probably in his turn present 
promises. Now, when it comes about that each man holds 
from the other promises to pay money, no actual payment will 
be required from either. If Mr. A owes Mr. B twenty dol- 
lars for a load of hay, and Mr. B owes Mr. A twenty dollars 
for a hog, it surely would be a waste of time and effort for 
either to present cash. Rather, they can cancel their promis- 
es, and so both men will be spared the trouble of either re- 
ceiving or delivering sums of actual money. Around this sim- 
ple idea has grown up the complicated process called credit- 
money-exchange, or more shortly credit exchange, which has 
in EngHsh-speaking countries an importance beyond all meas- 
ure. 

The nature of credit exchange can be made clear by be- 
ginning with credit exchange between two persons only, — hook 



CREDIT EXCHANGE 



157 



■credit, as it is usually called. In a case of reciprocal buy- 
ing between two persons at the same time, it is obviously need- 
less for each to deliver the payment money. The natural pro- 
cedure is to compute the balance of the mutual obligations and 
have that balance paid by the one against whom it falls. Fur- 
ther, if the two traders can trust each other, a similar proce- 
dure is possible where mutual purchases are made at different 
times; for each can sell to the other without getting his pay, 
or by receiving as pay the right to claim money later; and at 
some future date the reciprocal obligations or debts thus cre- 
ated can be partly, perhaps almost entirely cancelled, leaving 
only the balance to be cleared in money. In this simple case, we 
have the essential feature of credit-exchange ; it consists in 
bringing about a reciprocity of debts so that a considerable 
cancellation is possible and actual money is needed only to 
pay the balance. 

In the instance cited we have reciprocal buying, reciproci- 
ty of debts, and so a possible cancellation of debts between 
two persons. But circumstances of this exact sort are com- 
paratively rare. We do not usually buy from, and sell to, the 
same individual or set of individuals ; we are far more likely 
to buy from one set and sell to another. Thus, the farmer sells 
his com and oats to the elevator company and buys nothing 
from that company whatever; while he buys clothing, car- 
riages, lumber and other commodities from a set of merchants 
to whom he sells nothing whatever. 

Even in this situation, however, a true reciprocity of debts 
exists, — only it exists between any one person and all the 
rest taken together. If the farmer could in some way take 
what he owes every one and set it over against what every 
one owes him, a practically complete cancellation would be 
possible. He may not sell anything to that particular one of 
his neighbors from whom he has bought something; but he 
will almost certainly sell to some of those neighbors. As an 
offset to their claims against him, taken as a whole, he can 



158 PRINCIPLBS OF ECONOMICS 

therefore bring forward claims in his favor against them, 
taken as a whole. If, then, we can arrange to have all or 
many of a man's debts to his neighbors pooled, lumped to- 
gether, and all of their debts to him pooled, cancellation may 
easily be effected. We can, and do, carry out this plan by 
making some single institution a sort of common debtor and 
creditor, and allowing it to effect settlement with each of its 
patrons, as itself the representative of all the rest. 

The institution which commonly serves different individ- 
uals in this capacity is the so-called commercial bank or the 
commercial department in some other type of bank. The pri- 
mary functions of such an institution are, in ordinary banking 
language, deposit and discount : to care for the current funds of 
its patrons and make short advances to them as the need may 
arise. But an institution which takes care of its patrons' cur- 
rent funds almost inevitably is called on to make payments 
for them — at least this is the case in most English speaking 
countries ; and in doing that it naturally drifts into the posi- 
tion of common debtor and creditor. When Mr. A, one of the 
bank's depositors, orders the bank by check to pay $20 to an- 
other depositor, Mr. B, and Mr. B deposits the proceeds of 
the check in the same bank, this act makes Mr. A the debtor 
of the bank for. $20 and makes Mr. B the creditor of the bank 
for the same amount. When, now, some other depositor or- 
ders the bank to pay $18 for him to Mr. A, the latter becomes 
a creditor of the bank for this $18, which is entered on his 
account, cancelling all but $2 of the debt created by A's $20 
check in favor of B. So, when B gives still another depositor 
of the bank a check for, say, $25, he thereby becomes the debtor 
of the bank, the pooling agent, for $25, which is cancelled by 
book entries against his former credit of $20, leaving a debit 
balance of $5.* 

* It should be remembered that each depositor is expected to keep 
some balance with the bank, a practice which insures that the bank can 
safely assume the position of debtor on behalf of the man who writes 
a check in favor of another depositor. 



CREDIT EXCHANGE 159 

Thus the process goes on indefinitely. Every check drawn 
by A makes him a debtor of the bank for the amount named, 
and every check drawn by another depositor in A's favor 
makes him the creditor of the bank for that amount ; and the 
same is true of B or C, any one of the whole list of deposit- 
ors. In short, we see perfectly fulfilled the conditions men- 
tioned as necessary for the working of credit exchange. Reci- 
procity is established between debts or claims ; A's debts to 
other people are set over against other people's debts to him. 
And, given this reciprocity, cancellation becomes possible, and 
so credit exchange — exchange without the use of money — be- 
comes possible. 

In the preceding illustration we have supposed that Mr. A 
and his neighbors all keep deposits in the same bank. But gen- 
erally there are several banks in one community ; some are 
used by a part of the population and some by another part ; 
and Mr. A, whose transactions we may suppose are many and 
various, will have debits and credits to settle with the patrons 
of banks other than his own. At first sight, this seems to re- 
sult in a return to cash exchange, since a check on one bank 
deposited with another will not be debited to the former bank 
for any length of time, but will be promptly presented for 
cash. In fact, however, the bank which is debtor because of 
the supposed transaction will doubtless have come into pos- 
session of checks on the creditor bank which it can use to off- 
set the claim against itself. Even if it has at the time no 
claims against that particular bank, it will certainly have some 
against other banks in the community ; and, since all the banks 
will settle their mutual obligations on a pooling plan, these 
claims against other banks will do just as well in offsetting 
its debits as claims against its actual creditor. 

We thus come to another very important development of 
credit-exchange, the clearing, or settlement of mutual obliga- 
tions among a number of different banks. Here the same de- 
vice which enables Mr. A to adjust his debits and credits with 



i6o PRINCIPLES OF ECONOMICS 

a minimum use of actual money, is applied to settle the mu- 
tual obligations of banks. In general, the plan is to set up a 
common agent, a clearing-house association, which becomes 
the creditor of each bank for claims of all other banks against 
it, and becomes its debtor for claims against all other banks. 
At regular intervals a balance is struck and the one which 
proves to be debtor, the bank or the clearing-house, pays the 
balance. Naturally, the clearing-house settles first with the 
banks which prove to be debtors, and then uses the money thus 
obtained to pay the creditor banks. 

Our discussion has thus far had to do with exchange car- 
ried on through banks between persons in the same commu- 
nity. Another and much older form is inter-local credit-ex- 
change, or what we call Exchange in the preeminent sense. 
This form is resorted to for making payment between differ- 
ent cities and countries with a minimum use of money. Here 
we have again the same familiar device : claims for and against 
different countries, debits and credits, get into common hands 
so that reciprocity is established and cancellation is made pos- 
sible. Certain institutions in each country, banks or exchange 
houses, buy up all the claims on the other countries and also 
sell for the use of their patrons claims on those other coun- 
tries. Thus, they become the common creditors and the com- 
mon debtors of the dealers of their country in its relations to 
others ; and the debit and credit relations which they main- 
tain with other countries are maintained with institutions sim- 
ilar to themselves. It therefore becomes easy to set the debits 
of a country over against its credits, cancel these in so far as 
they are equal, and effect a complete settlement by paying a 
small balance in money. 

Section B. Instruments of Credit Exchange 

Just as coins and bills of different substances constitute the 
instruments or media used in money exchange, so a variety of 
paper documents constitute those used in credit exchange. Some 



CREDIT EXCHANGE i6i 

of these take the form of a direct promise between man and man 
to deliver a specified amount of money at a specified time. But, 
inasmuch as the promise must ordinarily be made good 
through the agency of a third party or institution, most of 
these documents are really orders made by one person, called 
the drawer, in favor of another person, called the payee, upon 
a third person or institution, called the drawee. If the payee 
does not himself find it convenient to present the document to 
the drawee for cash or for cancellation against his own prom- 
ises to the drawer, he can transfer it to another person by en- 
dorsement — writing his own name across the back, with or 
without some specific directions as to payment. 

The most familiar credit instrument is the bank check 
which has already been mentioned. It is an order for the pay- 
ment of money drawn by a man upon the bank where his own 
money is kept in deposit. It is used principally within a sin- 
gle town or limited community where the drawee bank is lo- 
cated, and where both drawer and drawee are known. Inter- 
local exchange makes little use of the check, preferring instead 
other instruments specially adapted to its purposes. Most 
important of these is the bank draft, an order for the payment 
of money drawn by one bank on a bank in another place, in 
favor of another party. A bank draft is employed when the in- 
itiative in settling a debt is taken by the debtor. He buys the 
draft, and mails it to his creditor ; the creditor then gets cash 
or credit for it from his bank ; and the bank, if not itself the 
drawee named in the draft, proceeds to collect from the bank 
which is. Another class of exchange instruments similar to 
the bank draft, are so-called money orders, — postal or express 
orders. These are drawn by local agents of the institution issu- 
ing them upon the central office, are sold to the debtor, and sent 
by him to the creditor, who collects from the agent of the is- 
suing institution located in his own town. When the initia- 
tive in settling a transaction is taken by the seller or creditor, 
the instrument employed is named a bill of exchange, though 



1 62 PRINCIPLES OF ECONOMICS 

this phrase is also, often appHed to international bank drafts. 
Such a bill of exchange, also called a commercial draft, is an 
order for the payment of money drawn by a seller or creditor 
upon his debtor in favor of the drawer or his banker. (If in 
favor of himself, he endorses it over to his banker.) The 
creditor turns the draft over to his banker and gets credit for 
the amount named, whereupon the banker sets out to collect 
from the drawee through banking correspondents. 

Section C. The Rate of Exchange 

A matter of much importance in connection with credit- 
exchange is the rate of exchange, particularly the rate in 
foreign exchange. As we have just learned, money payments 
between the people of different communities are effected 
through agents who assume the position of common creditor 
and common debtor for each community. An agent in one 
community buys up money claims on other communities from 
persons having such claims to dispose of ; and he sells money 
claims on other communities to persons needing them to make 
payments in those other communities. Thus, there is devel- 
oped a traffic in such claims, a traffic in "exchange," as it is 
called; and the price at which exchange sells — at least ex- 
change between different countries — is called the rate of ex- 
change. Stated more formally: the rate of exchange is the 
price in one country paid in the money of that country for the 
right to dispose of a unit of the money of some other country 
in that other country, or at least in some country other than 
the one in which the purchase is made. Thus, if I wish to buy 
from my bank the right to have five pounds sterling paid on 
my behalf in London, and find myself obliged to pay for that 
right $4.87 per pound, I say that the rate of exchange on Lon- 
don is $4.87. 

In domestic exchange, — exchange between different parts 
of the same country, — ^the rate of exchange usually means the 
difference between the face value of an instrument of ex- 



CREDIT EXCHANGE 163 

change and what is paid for it. Thus, if I say that the Chi- 
cago rate of exchange on New York is 15 cents premium per 
thousand, I mean that, in selHng a claim for $1,000 on New 
York, a Chicago dealer would get his $1,000 and fifteen cents 
additional. 

In working out the price or rate of exchange, the market 
starts with the natural value of the unit of the money want- 
ed, as measured in the money with which it is bought — that 
is, the value as it would be if there were no difference of place, 
if the buyer of Enghsh money bought it right in New York 
to be delivered in New York. If the two countries have the 
same standard, then the natural value of either money in 
terms of the other can be ascertained by a simple operation in 
division. Thus, one dollar contains 23.22 grains of fine gold; 
and the English pound, 113 grains. The pound, therefore, is 
naturally worth in our money as many dollars as 23.22 is con- 
tained in 113, or $4,866. This natural price of a foreign 
money unit, measured in terms of the home money, is techni- 
cally known as the par of exchange. 

The rate of exchange varies above or below the par of ex- 
change according as the demand for exchange at par is in ex- 
cess of the supply or vice versa. If the United States is sell- 
ing great quantities of cotton and wheat to the people of Eu- 
rope and buying comparatively httle from them, then claims 
on Europe will be abundant and, other things being equal, 
cheap ; those Americans who have claims on Europe to sell 
will be obliged to sell them cheap, while those who need such 
claims can buy them cheap. On the other hand, if the United 
States is buying many goods from the people of Europe and 
selling them comparatively few, then claims on Europe will be 
scarce and, other things being equal, dear; those Americans 
having claims on Europe to sell can obtain high prices, while 
those needing to buy such claims will be obliged to pay high 
prices. 



1 64 PRINCIPLES OF ECONOMICS 

These variations of the rate of exchange above and below 
par are limited by the cost to exchange houses of transporting 
the money itself from the one place to the other, — it being un- 
derstood that cost includes a reasonable profit to the exchange 
dealer. Any wider variations would give exceptional profit to 
the exchange dealers, which would stimulate their competi- 
tion, and so reduce the difference to this amount. In London 
exchange, the possible variation from par is commonly in the 
neighborhood of three cents ; in other words, the rate ranges 
from about $4,835 to $4,895. 

Ir.LUSTRATivS Probi^Ems 

1. Suppose that you send a check on the National Bank of 
Ann Arbor to the Newcomb-Endicott Company of Detroit to 
pay for some goods purchased; and suppose that when the 
check finally gets back to you it shows the following endorse- 
ments : (i) Pay to the Peninsular Savings Bank of Detroit, 
the Newcomb-Endicott Company. (2) Pay to the State Sav- 
ings Bank of Ann Arbor, Peninsular Savings Bank of Detroit. 
(3) Paid through the Clearing House, State Savings Bank of 
Ann Arbor. Trace the course of this check from the endorse- 
ments. 

2. Henry T. Crouch of Erie buys $1,275 worth of wheat 
from T. C. Craig of Detroit. 

(a) Suppose settlement to be effected with a wheat bill 
of exchange (also called a sight draft) and write out the sub- 
stance of the bill which would be used. 

(b) Suppose settlement to be made with a check and 
write out a facsimile (in substance). 

(c) Suppose settlement to be made with bank draft and 
write out a facsimile (in substance). 

3. Whichever method of settling the transaction involved 
in the last problem is used, the particular credit document em- 
ployed will inevitably take quite a journey from bank to bank 
while it is being collected. 

(a) Describe an imaginary course, which it would very 
likely take if it were a sight bill of exchange. 



CREDIT EXCHANGE 165 

(b) Same, if it were a check. 

(c) Same, if it were a bank draft. (Compare Prob- 
lem I.) 

4. We buy a good deal from Brazil, but sell her 
little. We sell a great deal to Great Britain, but buy from her 
much less. Can you imagine a way in which one of these 
trades furnishes a medium of exchange for the other? 

5. Oct. I, 1907, the different banks of Ann Arbor brought 
to the clearing claims against each of the other banks as fol- 
lows: 



No. I against 


No 


. '2 against 


No. 


5 against 


No. 2 $2213.19 
No. 3 1865.09 
No. 4 2415.96 
No. 5 512.21 


No. 
No. 
No. 
No. 


I $4284.78 

3 2172.45 

4 3043-18 

5 655-87 


No. 
No. 
No. 
No. 


1 $4974.66 

2 1607.79 

4 1093-24 

5 625.88 



Total $7006.45 Total $10156.28 Total $8301.57 
No. 4 against No. 5 against 



No. I $3078.73 No. I $ 332.15 

No. 2 1793.16 No. 2 377.17 

No. 3 973.73 No. 3 1515.46 

No. 5 4633.96 No. 4 181.56 



Total $10479.58 Total $2406.34 

Compute the balance for or against each bank. 

6. Supposing all the claims of the Ann Arbor banks on 
one another which appear in the last problem to have consisted 
of checks which were used in the regular course of business 
transactions ; 

(a) What must have been the total volume, expressed in 
money, of the transactions thus efifected? 

(b) How much actual cash was needed to effect these 
transactions ? 

(c) What per cent of the total volume of transactions 
did this cash amount to? 

(d) What is the significance of these facts? 



1 66 PRINCIPLES OF ECONOMICS 

7. Not many years ago it was estimated that the per 
capita money circulation of England was about $11 while 
that of France was about $51 ; yet, as every one knows, there 
was at least as much business per capita carried on in England 
as in France. How could the difference in the amounts of cir- 
culating medium required be explained? 

8. Some writers represent the development of credit-ex- 
change as a return to barter. Show that this is not true — that 
credit-exchange is still mediated exchange, nay more, that it 
is money exchange. 

9. Suppose I wish to buy a bank draft for i200 on Lon- 
don. With Eondon exchange at $4,855, what should I be able 
to get the draft for? 

10. A wheat exporter of New York draws a bill on his 
London customer for f 1375. What should he be able to get 
for this bill with London exchange selling at $4.87 ? with Lon- 
don exchange at $4.84? 

11. Suppose that a New York importer can get 50 gross 
of Sheffield razors delivered in New York for 44 pence each 
(the duty included), and that he can sell them for 95 cents 
each. What would be his profit on such a transaction if the 
rate of exchange on London were $4.84? if the rate were 

$4.87? 

12. From the last two problems what principles can you 
deduce as to the effect which a high or low rate of exchange 
tends to have on exports? on imports? 

13. "The greater part of our circulating medium con- 
sists, not of money, but of deposit currency." Explain what 
is meant by deposit currency. 

14. Near what point would you expect the rate of ex- 
change on Europe to be found in the fall of the year? Why? 

15. "A matter very frequently overlooked by the public 
is that a large share of the bank deposits of a country like the 
United States grow out of loans and so do not add to the 
cash holdings of the banks." Explain how this is so. 

16. When exchange on London is at $4,895 or there- 
abouts, it is said to be at the upper gold point; and when in 
the neighborhood of $4,835, it is said to be at the lower gold 
point. Why are these called gold points? 



CHAPTER XII 

SOME ELEMENTARY PRINCIPLES WITH RESPECT 
TO MONEY 

Having briefly analyzed and described the system of Mon- 
ey and Credit Exchange, it is now in order to set forth some 
of the principles governing that system. It is much too early 
in our study to attempt anything resembling a thorough expo- 
sition of the theory of money. Nevertheless a few of the sim- 
pler principles which, though little more than truisms, are fre- 
quently overlooked by the public with the result that foolish 
errors gain acceptance and lead to hurtful legislation, should 
receive attention at the very outset. 

The first point requiring emphasis has to do with the com- 
mon fallacy which regards, or seems to regard, money as the 
only kind of wealth. In earlier centuries, whole communi- 
ties have entertained such an idea, and even in our own day 
many people stand dangerously close to the same position. 
Anything that reduces the monetary stock of a community 
tends, in their opinion, to make that country poorer, no mat- 
ter what the reducing force may be ; and anything that increas- 
es the monetary stock, whether a balance of trade causing the 
import of money from other countries, or coinage by the gov- 
ernment within the country, must have the effect of increasing 
wealth. 

There is no doubt some little excuse for this attitude of 
mind in the predominant place which money holds in our 
every day thought and speech concerning wealth. We express 
M^ealth, of whatever kind, in terms of money, for example, 
when we say that "Smith has inherited a half million of dol- 
lars," though as a matter of fact he has inherited only land, 
factories, and stocks valued at a half million dollars. It is a 



1 68 PRINCIPLBS OF ECONOMICS 

fact, too, that money will procure for us any other kind of 
wealth we may desire, and hence itself appears to us the most 
efficient and desirable form of wealth, the wealth par excel- 
lence. Nevertheless these considerations surely do not jus- 
tify us in conceiving money to be the only form of wealth. 
Any kind of goods capable of yielding satisfactions and hav- 
ing exchange value — diamonds, bullion, land, or what not — 
are wealth just as truly as coined money. It is essential there- 
fore to keep always in mind the following proposition: 

I. Money is simply one particular kind among many 
kinds of wealth. 

The second fact needing to be insisted on at this point is 
that money is not the only kind of capital. Considered as an 
instrument which we employ to facilitate the exchange of 
goods and to accumulate or transfer stores of value, money is 
of course capital, just as truly as buildings, engines, or ma- 
chinery. But certain peculiarities of money have led careless 
persons into thinking and talking about it as if it were the 
only true capital. Thus all forms of capital, like all forms of 
wealth in general, are computed and expressed in terms of 
money, as when we say, "Mr. Craig has $200,000 of capital 
in the milling business." We seem to mean here that $200,000 
in money constitutes the capital which Mr. Craig devotes to 
the production of flour; but what we should mean is that 
Craig owns and devotes to such production certain buildings, 
dams, races, and machinery which have a value measured in 
money of $200,000. He may not, and almost certainly does 
not, possess anything like that amount of money capital, as 
money. 

Again, people are sometimes led to look upon money as the 
only form of capital, from the fact that money constitutes the 
immediate form in which most capital is accumulated. A per- 
son desiring to accumulate a fund of capital, to invest in the 
milling business, let us say, puts away his savings in the form 
of money or credit with his bank; and only after the sum of 



BLBMENTARY PRINCIPLES OF MONEY 169 

money or credit has grown large does he part with it, obtaining 
in exchange the capital goods — lumber, engines, and machines — 
necessary to commence production. Still, the money stage 
of capital is obviously only temporary and transitional; it 
lasts only while enough is being stored up to bring in return 
an appreciable amount of other capital. It is moreover only a 
representative form of capital, the shadow or image, not the 
substance. At the same time that the capitalist is accumulat- 
ing stores of money or bank credit, other men are manufactur- 
ing, practically, if not literally, to his order, lumber, engines, 
and machines ; and these other things for which the capitalist, 
or someone who borrows from him, exchanges his store of 
money or bank credit, constitute the real, final, form of capi- 
tal. The truth embodied in the following proposition should, 
therefore, be constantly borne in mind. 

2. Money is simply one among many kinds of capital 
{capital goods), i. e., products zvhich are wanted, not for their 
own sakes, hut for the sake of other things which we can get 
through them; and relatively, money forms a rather small 
portion of the total capital of the community. 

Another mistaken notion with respect to money, which has 
caused a great deal of trouble in the past and is still very 
widely held, conceives that a country can never have enough 
money, — can to advantage increase its stock of this particu- 
lar form of capital indefinitely. Every addition is eagerly wel- 
comed ; every withdrawal is looked on with anxiety. Increas- 
ing the quantity of money is offered as a panacea for almost 
every undesirable feature of business. All this is, of course, 
very hard for the student to comment on with patience. The 
quantity of money a country can advantageously supply itself 
with is wholly a matter of the need, the money work to be 
done, over against the quantity of its resources which it can 
afford to use to satisfy this particular need in view of the re- 
lation between its total needs and its total resources. Doubt- 



I70 PRINCIPLES OP ECONOMICS 

less there is no way of ascertaining with precision just how 
much this means. But that it is a Hmited amount no one 
would deny. The actual work in which the money stock of a 
country is at any moment being employed is serving as re- 
serves behind the credit of the country, passing from hand to 
hand in exchange for goods and in payment of obligations, 
and being held by people in reserve for current uses and in 
the process of accumulating capital. For the uses which in- 
volve passing from hand to hand, any particular pieces of 
money will be used over and over again so that the total need- 
ed for this purpose will be much smaller than the total amount 
of work to be done would seem to indicate. Further, a large 
share of the money work of this kind needing to be done 
is performed by credit substitutes which are extemporized for 
each transaction ; and their volume has little reference to the 
quantity of money proper in the country. It is thus possible 
that the country should experience great changes in the money 
work to be done without any inconvenience resulting, even 
though the quantity of money had not shown a corresponding 
change. 

But not only is the community's need for money a quite 
limited quantity, it is surely very foolish to want to have more 
than this. To insist on supplying ourselves with a larger 
amount is like filling up one's house with cook stoves or tubs 
or washing machines. Any time or energy which we expend 
in acquiring such objects beyond the needs of the kitchen and 
laundry lays upon us a burden in caring for them, and, worse, 
it reduces the time and energy which we have to use in sup- 
plying ourselves with fuel, food, clothing, and other needed 
articles. Putting this point into a formal proposition gives us 
a third principle. 

3. Money is simply one particular kind of useful instru- 
ment of which our stock should be large enough to do the 
money work needing to be done a^ well as we can afford 



ELEMENTARY PRINCIPLES OF MONEY 171 

to have it done, but of which we do not want an excess any 
more than we zuant an excess of chairs, clothes, stoves, en- 
gines, or any other useful article. 

A fourth widely accepted fallacy connects itself with the 
supposed advantages of "putting money into circulation." Ex- 
actly what this phrase means in popular usage is often hard 
to determine. If. it means causing money to flow, or pass from 
hand to hand, the phrase is merely an empty one without ex- 
cuse for being. Money is always in circulation, passing from 
one person to another in purchase of goods, or held awaiting 
occasion for such use. It will circulate anyway ; from its very 
nature it is bound to circulate. Or perhaps the phrase means 
to render money more active, cause it to spend a greater part 
of the time actually going through the air, effecting exchang- 
es, instead of lying motionless in men's pockets. But to ex- 
pect that any benefit will result from causing money to change 
hands a greater number of times in an hour or in a day is of 
course absurd. There is nothing beneficial in the exchange, 
per se, of money, because there is nothing beneficial in the ex- 
change, per se, of goods. The exchange of goods should oc- 
cur just often enough to enable us to dispose of those we have 
produced and to get possession of other goods which will be 
of most advantage to us as consumers. Any more exchang- 
ing would be, obviously, a waste of our time and effort. But, 
since money passes from person to person merely as a counter, 
a check against other goods, the number of times it can ad- 
vantageously change hands is limited to the number of times 
those other goods can advantageously change hands. To pass 
it more frequently — if that were possible — would be merely a 
purposeless waste. 

There is one other possible interpretation for the phrase. 
By "putting money into circulation" some people mean creat- 
ing a demand, which would not otherwise exist, for goods and 
services, thus increasing the sales and the incomes of people 



172 



PRINCIPLES O'F ECONOMICS 



generally and making the whole community more prosperous. 
This belief is no more tenable than the ones just discussed; 
but since the particular fallacy involved is one in contraven- 
tion of a principle of trade which we designate Say's Law, and 
which is treated in the next chapter, we must reserve the con- 
sideration of this fallacy for that connection. The chief point 
of our present discussion may be summarized as follows : 

4. Broadly speaking, it is of the very nature of money to 
circulate {in person or by proxy), that is, to pass from one 
person to another in purchase of goods or to be held awaiting 
the occasion for such use. 

Another truism which needs only to be understood to com- 
mand immediate acceptance, and yet is constantly overlooked, 
has to do with the fact that the stock of money is not neces- 
sarily any measure of the existing wealth of a community. 
When we complain of the squandering of a great capital by a 
worthless heir, people at once say, "I don't see that any harm 
is done. The money spent by the foolish heir is still here. It 
has only been transferred to better hands." 

Of course the money is still here. Money is a bit of so- 
cial machinery of a highly durable character, which lasts al- 
most indefinitely, needing only small additions to keep it in- 
tact, like such permanent forms of capital as roads, canals, etc. 
Of course, then, the money is still in existence just as if the 
spendthrift had not thrown it about him so freely for yachts, 
dances, feasts, and other frivolities. But, on the other hand, 
there is a total lack of something else which would have come 
into being if the son had followed in the footsteps of his fa- 
ther. The father would have looked upon his money as a 
temporary or transitional form of capital, and would have 
gone on to consummate the process of capital production by 
the purchase of productive goods — engines, cars, bridges, 
shops. These goods could have been produced by the same 
labor which was expended in ministering to the young man's 



BLBMENTARY PRINCIPLES OF MONEY 173 

follies, and they would have continued for years to give off 
services, instead of totally disappearing, Hke the orchestra 
music or the champagne, over night. As a result of the young 
man's spending, therefore, society as a whole is vastly poorer 
than it might have been, even though the quantity of money 
is not altered in the least. 

5. Broadly speaking, it is of the very nature of money to 
remain m,oney — not to be consumed in the sense of being fin- 
ally absorbed into the life of any individual. Hence the fact 
that the stock of money is unchanged proves nothing as to 
how the amount of wealth or capital is affected by particular 
lines of conduct. 

A final fact deserving mention in this place relates to the 
effect of foreign trade upon the stock of money in any com- 
munity. "Everything we buy abroad," so runs a popular fal- 
lacy, "takes just so much money out of the country," and the 
conclusion is drawn that the country thereby falls into great 
economic distress. Now a moment's reference to the facts 
set forth in our analysis of the Credit Exchange should make 
clear to anyone the error in this belief. We do not make our 
purchases abroad with money, but with instruments of credit. 
In like manner, we sell our goods abroad, not for money, but 
for instruments of credit. These two sets of instruments are 
cancelled against each other, only balances going in money ; 
so that the amounts of money actually passing from one coun- 
try to another are very insignificant. Further, of course, those 
balances will naturally be in favor of any particular country 
just as much as against it. That is, there will very likely be 
no net movement of money at all. 

There is indeed one condition under which there will tend 
to be a net outward movement of money from a country prac- 
tically all the time. If we are a gold producing country and 
spend much of our strength producing this metal, and little 
in producing other goods which we can export to pay for our 



174 PRINCIPLES OF ECONOMICS 

imports, then, of course, the balance of credit against us will 
be great, and we will have to export much money to cancel 
it. But even here we are not exporting money in any true 
sense. If we spend much time producing gold, we probably 
mine, refine, and subsequently coin into money a far greater 
amount than we can advantageously use as money. So far as 
our internal business is concerned, therefore, this excess is 
hardly to be called money ; it is merely the metal, gold, a 
product of our labor, like wheat, or shoes, or pork, which we 
can and should ship abroad to those who desire it, in payment 
for the products which we desire of them. 

But, while a country which is a large producer of gold, 
the money metal, may show a large net export of this kind of 
money, this will not be the case with other countries. Those 
which produce none at all will in the long run show a net im- 
port of such money; while those which produce just about 
enough to meet their own needs will have neither a net export 
nor a net import. Between countries, as within countries, 
money will act just as a medium of exchange must act. That 
is, it will come and go, go and come, — being wanted not to use 
for eating or wearing or warming houses or for any purpose 
that involves retaining possession of it or destroying it, but to 
use in helping us to exchange our products for the products 
of other countries. 

6. It is of the very nature of money to go hack and forth 
between communities; trade with the outside world does not 
of itself tend to take atvay our money. 

IlIvUSTrative; ProbIvEms 

I. "Foreign trade can add to the national wealth only 
when it brings in a money balance." 

(a) What is the principal thing to be gained by main- 
taining trade relations with the outside world ? 

(b) When would it be of advantage to have our foreign 
trade bring in a money balance? 



ELBMENTARY PRINCIPLES OF MONEY 175 

2. "A nation is so much poorer by every dollar it sends 
out, just as an individual is so much poorer by every dollar 
he spends." Criticise both clauses. 

3. "Everything we buy abroad takes just so much money 
out of the country." 

Show that this can not be true whether it is meant that 
such buying abroad takes the money out immediately or only 
ultimately. 

4. Suppose that official reports from all the banks of a 
certain city show that, on an average, 93 per cent of the de- 
posits received during a certain day consisted of checks, only 7 
per cent being in the form of money. What important fact 
with respect to the conduct of business in that city would be 
thereby disclosed? 

5. "It is sometimes asked whether the raising of a gov- 
ernment loan to cover ordinary expenditures really causes 
capital to be lost, since the coins received by the government 
remain in existence, — even remain in the country. This objec- 
tion has no weight whatever." — Pierson's Principles of Eco- 
nomics. Show that the statement in italics is correct. 

6. "We pay no million dollars per annum for the carry- 
ing of products between this and foreign countries. Think of 
it. One hundred and ten million dollars in gold coin has gone 
out of the commerce of this country into the commerce of 
other countries. Can New York stand this?" — James G. 
Blaine in 1881. 

(a) Is it likely that we permanently lost no million dol- 
lars in gold from our circulation because we hired foreigners 
to carry our goods? 

(b) Is it hkely that we even temporarily parted with that 
much gold on that account? 

(c) Is it hkely that as a nation we should have been 
richer if we had done this carrying of products for ourselves? 

7. "I don't see that society as a whole loses anything by 
the giving of a fireworks exhibition costing $1,000. Of course 
the people who pay for the fireworks are just so much out. 
But then the $1,000 goes to the other people who furnish the 
fireworks so that society as a whole comes out even." Criti- 
cise. 



176 PRINCIPLES OP ECONOMICS 

8. Bills drawn against these heavy shipments (of cotton) 
flooded the foreign exchange market this week (Nov. 19, 
1903), depressing it to the lowest level since Nov., 1900." 

According to popular ideas, what result ought to have fol- 
lowed the heavy shipments of cotton referred to? 

9. "My numerous armies promote the circulation of mon- 
ey, and disburse impartially among the provinces the taxes 
paid by the people of the state." — Frederick the Great justi- 
fying his wars in a letter to D'Alembert. (Quoted from Bul- 
lock.) 

Was there anything in the facts stated to ofifset the sac- 
rifices undergone by the people in paying the taxes ? 

10. "The summer boarders are a great blessing to our 
little village ; because they put into circulation a lot of mon- 
ey, which means at least temporary prosperity." 

What must we understand this phrase, "put into circula- 
tion money" to mean, if we accept the above as anything like 
an adequate explanation of the prosperity brought by the sum- 
mer boarders ? 

11. "The individual can get rich only by selling more 
than he buys and saving the surplus in the form of money or 
bank-credit. So a country can increase its wealth only by ex- 
porting more than it imports, and taking the difference in 
money." 

Discuss both parts. 

12. "I am not convinced of the soundness of the ortho- 
dox doctrine that a country can have all the money it wants 
and needs, just as it can have all the engines, machinery, etc., 
which it wants. Money is very different from other things. 
It would be easy to give a man all the food and clothes he 
wants ; but, however much money you offered him, he would 
take it all gladly." 

Criticise. 

13. From a Salt Lake supporter of the "Seeing Ameri- 
ca" movement: "We recognize that Americans are annually 
spending $200,000,000 in foreign travel. That practically ev- 
ery dollar of this vast sum is lost to the home circulation can 
not be disputed." 

Criticise the last sentence. 



CHAPTER XIII 

CERTAIN FUNDAMENTAL PRINCIPLES OF TRADE 

The preceding chapter sought to emphasize certain elemen- 
tary principles governing the mechanism of exchange, princi- 
ples which, though little more than truisms, are often over- 
looked. For exchange itself — the process of trade between in- 
dividuals and communities — there are similar elementary prin- 
ciples which are so commonly neglected or misunderstood as 
to call for immediate comment. One of these, perhaps the 
most fundamental of all, has already been given on page 25, 
in the proposition that the chief function of exchange is to 
make co-operation and specialization possible. We must now 
add three others, scarcely less important, known as Say's Law, 
the Principle of Reciprocity, and The Law of Comparative 
Costs. 

Section A. Say's Law 

The first of these principles has to do with the conditions 
which determine the total demand for goods. Demand, as 
understood by the economist, means the quantity of any goods 
which buyers actually stand ready to take, as conditions are, 
including the existing price. Demand in this sense obviously 
implies the existence of desire on the part of buyers, coupled 
with power to buy, — control of some adequate equivalent to be 
exchanged for the thing desired. The definition will be more 
fully explained in the next chapter, but for the present this 
much will suffice. 

One of the most popular notions, and an entirely erroneous 
one, as to how the general demand is determined, will per- 
haps serve best as an introduction to the really sound doctrine. 
The error in question takes its origin in the natural anxiety 



178 PRINCIPLES OF ECONOMICS 

of each individual producer to increase as much as possible 
the demand for his own particular product. In order to pro- 
mote this result he expends much effort both in trying to make 
his product exceptionally good, and in convincing buyers of its 
goodness ; and, so far, his methods are quite legitimate. But 
he is seldom content with this. He wishes to enlist the con- 
scious support of his neighbors and fellow citizens acting in 
their personal capacity or through public legislation. For ex- 
ample, he tries to get the rich into the way of spending their 
money liberally, or he urges the government to raise the mon- 
ey by taxation and undertake expensive improvements. But, 
in order to enlist the support of producers generally in his 
scheme, he must seem to show that the scheme would be of 
advantage to those other producers as well as to himself. 
Hence, he argues that the demand for his own goods, which 
he is seeking thus to increase, will indirectly but none the less 
surely increase the demand for goods in general. A similar 
argument is often advanced in relation to happenings of a de- 
structive nature. A government may be wasting the substance 
of an industrious people carrying on a foolish and costly war, 
and when economists complain, someone promptly answers 
that it is a good thing because it creates a demand for goods. 
A tornado which blows off a farm house roof is observed by 
many — not including the farmer — to have the same consoling 
feature. 

What people mean is that the tornado, to use a single ex- 
ample, sets up a chain of purchases which would not otherwise 
be made. The householder whose roof is blown off at once 
proceeds to buy shingles and hire carpenters ; the carpenters 
and the lumber dealer, finding their incomes increased, buy 
more groceries and clothes ; the grocer and clothier, taking 
their unusually large receipts, improve their stocks by pur- 
chase from the wholesaler, or spend more freely for pleasure 
rides and concerts. Thus the purchases made by the roofless 
householder extend themselves indefinitely down the line, 



PRINCIPLES OF TRADE 179 

business quickens everywhere, the prosperity of the whole 
community is heightened. 

This reasoning sounds plausible at first, but is in fact fal- 
lacious. To detect the fallacy we must go back to our house- 
holder and watch him during the hour after his roof has dis- 
appeared and before he calls in the lumber dealer and the car- 
penters. Possibly the man has cash in his pocket sufficient to 
pay for the repairs. More probably he has not, since all his 
savings but a dollar or two are usually kept in the bank. He 
either takes the money from his pocket or draws a sum from 
the bank and spends what he must for lumber and carpen- 
ters. Thus his money creates demand, and starts a chain of 
purchases. 

But, now, if we consider this fund of money more closely, 
we see that it would have created the same quantity of demand 
for goods and services anyhow. If our house owner has the cash 
in his purse, he must be keeping it there temporarily, intending 
to spend it for commodities or services to be devoted, per- 
haps, to putting a new cellar under his house. Or suppose he is 
not intending to spend the money at present, and so is keep- 
ing it in a bank ; it is not locked up there, we may be sure, 
but is being loaned out more or less constantly to borrowers 
who are using it to purchase commodities or services. For 
the sake of simplicity, let us say that it is loaned to some one 
who plans to use it putting a cellar under his house. A neces- 
sary result, then, of spending this money to repair the broken 
roof is to prevent it from setting up another chain of purchas- 
es, starting with those needed to excavate the cellar. This 
other chain would have begun with the hiring of cellar dig- 
gers and the buying of cement ; the diggers and cement deal- 
ers would then have spent more for furniture and dental serv- 
ice ; and the furniture merchants and dentists in their turn 
would have spent more for automobiles and real estate. In 
short, the purchases made by the householder in digging a new 
cellar would have extended their influence endlessly, stimu- 



i8o PRINCIPLES OP ECONOMICS 

lating business and apparently bringing prosperity into the 
world, just the same as purchases made to repair a roof 
whisked off by a tornado. Hence the tornado does not increase 
demand in the least, it merely substitutes one chain of pur- 
chases for another."^ 

What, now, is the point to be made from the story of our 
house owner? Immediately, it is this. The contribution made 
by any one person to the total demand for goods is, in the 
long run, bound to be just equal to his income, no more and 
no less. He can not demand more goods than that income 
will buy; he or some one who borrows his money is certain 
to demand as large a quantity as that income will buy. 

But this only starts us on our way. What determines the 
quantity of his money income? Broadly speaking, this is de- 
termined by the amount of goods or services which, under ex- 
isting legal conditions, is credited to him as his product.** It 
follows that the contribution to total demand made by any- 
one is necessarily equal to the quantity of his product : it can 
not be greater; it m^ust be as great. Finally, since the total 
demand of a community necessarily consists of the sum of the 
demands made by the individuals who constitute the commu- 
nity, the total demand of that community must equal its total 



* Incidentally, too, we should note that, from the standpoint of 
the original householder, the chain of purchases which would have 
been started by digging a cellar is much more desirable than the one 
actually started by repairing the roof. The second process leaves the 
man with a house no better than before — a house having a roof but 
no cellar. The first would have left him a house already sufficiently 
well roofed, and improved by the addition of a cellar. Hence, while 
business in general gains nothing from the tornado, the householder 
suffers a positive loss. 

** This is not to be taken as meaning that the individual is moral- 
ly entitled to the particular income which he is receiving on the 
ground that he produces it. The product is here whether or not the 
right man is credited with it; and the value of that product deter- 
mines the volume of demand resulting, whoever ought to control that 
demand. 



PRINCIPLES OP TRADE i8i 

product : it can not be greater ; it is bound to be as great. But 
these propositions are so important that they must be more 
specifically defended. 

I. Demand can not he greater than product, — can not, at 
bottom, include anything outside of product. Imagine a shoe- 
maker who makes nothing but shoes desiring to obtain a 
quantity of wheat from a wheat farmer who raises no other 
grain. Obviously, the only way he can hope to obtain wheat 
is to ofifer shoes — either directly on the barter plan, or in- 
directly through a money medium — in exchange. But these 
shoes which he offers he must first have produced—they are 
a product; hence the shoemaker's demand for wheat cannot 
include anything outside of his product, (shoes). Reversing 
the hypothesis, if the wheat grower desires a new pair of 
shoes, his demand for shoes cannot include anything outside 
of his own product, (wheat) ; he simply has nothing else to 
demand zvith. Now, if this is true of two people in their rela- 
tion to each other, it must be equally true of one person in his 
relation to society as a whole : the demand made by shoemakers 
for market goods of all kinds can include nothing but shoes 
produced by them and offered on the market ; the demand 
made by wheat growers for market goods of ail kinds can in- 
clude nothing but wheat produced by them and offered on 
the market — in each case nothing else will serve as a demand 
for goods in general except something which the individual 
has himself produced. Finally, this proposition, being true of 
every individual, must be true of all individuals taken togeth- 
er. The demand of all the people in the community, the total 
demand, can be no greater than the product of all the people 
of the community, the total product. Finally, what is true of 
each nation in its relations with the rest of society, is equally 
true of all society, of the whole world, in its complex, intricate 
relations with itself. The demand made by all society for 
market goods of all kinds can include nothing hut goods tvhich 
the same society has produced and offered on the market. 



i82 PRINCIPLES OF ECONOMICS 

2. Demand must include all of the goods produced for 
the market — assuming that producers have directed their pro- 
duction in true accord with one another's wants. 

Presumably all goods produced for the market will be of- 
fered in exchange, that being the purpose of their produc- 
tion, and, when offered in exchange, all these goods consti- 
tute a demand for other goods. Thus the shoemaker pro- 
duces, say, two pairs of shoes each year for his own use, and 
a hundred pairs for the market; and every one of these mar- 
keted pairs constitutes a demand for wheat, cloth, wood, and 
so on. In other words, everything which the shoemaker of- 
fers in exchange, demands something else to be given in ex- 
change. That the same proposition will hold true of all other 
individuals, of nations, and of society as a whole will perhaps 
be accepted without further argument. Everything which so- 
ciety (any part of it) produces for the market will, when of- 
fered in exchange, constitute a demand for other goods which 
society itself (some part of it) has produced. 

The unfaiHng applicability of this principle can best be 
shown by reference to a situation where it is generally sup- 
posed to fail. "Every true friend of labor," so runs an old 
argument, "must condemn without reserve all prison systems 
which devote convict labor to the production of goods for the 
market. Every such system must, in the nature of the case, 
increase the supply of commodities without increasing the de- 
mand, and so must diminish the employment available for 
honest laborers who keep out of prison." As a matter of fact, 
the goods produced by convicts in prison add just as much to 
the demand as they do to the supply ; the goods are exchanged 
by the prison authorities, either on a barter plan or by use of a 
money medium, for other goods which the prisoners need, and 
so, proportionally, add to the total demand for goods. To be 
sure, the prisoners must necessarily be supported anyway, and 
the demand for the particular products they need will exist 
whether they offer anything of their own producing in ex- 



PRINCIPLES OF TRADE 183 

change or not. But suppose for a moment that they do offer 
nothing. Then the goods or funds offered in exchange — in 
demand for — the goods they need, will have to be obtained 
by taxing the public. This, of course, while leaving the prison 
demand for those products needed by it just the same as be- 
fore, will diminish the taxpayers' demand for some of the 
same or various other products. Undoubtedly, then, the total 
demand for all products would not be so great as if the pris- 
oners worked and offered something in exchange. All goods 
produced for the market, under whatever conditions, consti- 
tutes a demand for other goods. Or, to return to our original 
proposition : demand must include all of the goods produced 
for the market. 

This statement must not be accepted, however, without the 
proviso which appears in the second clause of our proposition. 
"Assuming that producers have directed their production in 
true accord with one another's wants." Producers do not al- 
ways direct their production in true accord with one anoth- 
er's wants. Under primitive conditions, it was possible for 
any producer to estimate with a fair degree of accuracy the 
kind of product and the amount of it which would be needed. 
If a shoemaker had a hundred neighbors, none of whom made 
shoes, he could feel tolerably certain that at intervals not dif- 
ficult to calculate, he would be called upon to provide cover- 
ings for one hundred pairs of feet. Under modern condi- 
tions, the problem is not so simple. In many of our old and 
well established industries, the wants of the population can 
still be fairly well forecast. But the excessive increase in the 
volume of capital brings about a very low rate of profit in 
these industries. On the other hand, there are always spring- 
ing up new enterprises ; and the excess capital seeks invest- 
ment in these, where the profit may be high but where unfor- 
tunately the amount of output wanted by the public cannot 
be calculated at all closely. The result is that often some- 
thing is produced — let us say, theatres or summer furs or 



1 84 PRINCIPLES OF ECONOMICS 

railroad facilities — which people do not really want, or at any 
rate not in the volume offered. 

Now, as regards these excess products which nobody 
wants, our original proposition still holds true : every part of 
the product, and the whole of it, when offered on the market, 
constitutes a demand for other goods. But just here arises a 
discrepancy — some of the other goods which have been pro- 
duced and which should presumably be offered in demand for 
these summer furs and trips on the railroad, are not forthcom- 
ing. Some of the wheat, some of the shoes, some of the ma- 
chineiy is withheld from the market and not offered in ex- 
change for the summer furs — and why? Because the produc- 
ers of wheat, shoes, and machinery had expected to demand 
with these goods, not summer furs, but some different prod- 
uct, let us say automobiles ; some different product which the 
makers of summer furs would have produced if they had not 
gone into the fur business, but which are not now produced 
in large enough quantity or at low enough a price. Due to the 
misdirection of production by makers of furs, therefore, cer- 
tain other goods are temporarily kept in the store house ; or, 
if sold, they are sold only for money or credit, and these me- 
dia are not used, for the time being, to buy other goods — the 
exchange operation is left half completed.* The part of these 
goods which is not offered thus constitutes for the time being 
an excess of product over demand. Hence, to our original 
proposition that "demand must include all of the goods pro- 
duced for the market," it is necessary to add the proviso that 
"producers have directed production in true accord with one 
another's wants." 



* This last must not be understood to imply that exchange is 
never complete unless the money received for goods sold is in turn 
used to buy other goods. Occasionally, the money which a seller re- 
ceives for his goods is the ultimate thing he wants. For example, he 
may wish to get gold to use in making jewelry and may choose to do 
this by melting coins ; or he may have a fad for collecting gold coin 
just as another man might collect old pictures: 



PRINCIPLBS OF TRADB 185 

We have seen then that (i) Demand cannot include any- 
thing outside of product, and (2) demand must — with small 
exceptions — include all of the goods produced for the market. 
But, if demand cannot include anything outside of products 
and must include all of these, then demand and product must 
coincide. This is the point which we have been seeking to dem- 
onstrate. It is the essence of Say's Law, and for sake of em- 
phasis can now be stated as a formal principle. 

Principle. Say's Law. The Ultimate Identity of Demand 

and Product 

In the last analysis, the demand for goods produced for 
the market consists of goods produced for the market, i. e., 
the same goods are at once the demand for goods and the 
supply of goods; so that, if we can assume that producers 
have directed production in true accord with one another's 
wants, total demand must in the long run coincide with the 
total product or output of goods produced for the market. 

Illustrative: Problems 

1. "George Rankin is of course a big fool to spend $400 
making a mill dam in a creek which is dried up every sum- 
mer and never has enough water to run an ice cream freezer; 
but he is doing one good thing, — he is making a whole lot 
more demand for labor and so a lot more employment for 
laborers." 

Explain fallacy. 

2. "There is just so much work to be done. The en- 
trance of women and children into the field of labor must 
drive out an equal amount of adult male labor." 

Criticise. (There are no doubt objections of real weight 
to the extension of child and female labor; but this is not 
one of them.) 

3. "The real cause of the present standstill in trade is the 
inequality of incomes. There can be no effective demand, be- 



1 86 PRINCIPLES OP ECONOMICS 

cause those who have the money to buy have no unsatisfied 
wants, while those who have the wants have no power to 
buy." 

Criticise. 

4. In a certain part of a recent novel, Mr. Blossom, a 
young painter and decorator, is trying to induce Miss Cynthia 
to give him a job redecorating her house, which is somewhat 
behind the times in this respect. The latter part of the con- 
versation on the matter is as follows : 

" 'Live and let live' is a good enough motto for me." 
" 'Live and let live,' " repeated Miss Cynthia, thoughtfully. 
"What do you think that means?" 

"Why, it's plain enough," said Mr. Blossom, strongly. 
"You're living all right, ain't you? Got enough of everything 
and something to spare * * * * • \y^i you've got to let 
other folks live. * * * If there's anything you want done 
that you can't do for yourself, hire somebody that can do it 
* * * so they can live, too. If everybody did that right 
along, I guess there wouldn't be so much talk about labor 
unions and strikes and all that sort of thing." 

(a) Would Miss Cynthia's deciding to spend and actual- 
ly spending $600 to redecorate her house increase the em- 
ployment of laborers generally? 

(b) Why can we be certain that everybody is now doing 
the thing which Mr. Blossom thinks they ought to be doing? 

5. Street comment on a cold snap which bursts numerous 
water-pipes : "Hard on householders, sure enough ; but no 
great loss without some small gain. It's a bonanza for Ann 
Arbor plumbers." Is that sound? 

6. Mr. A, having earned and saved $10,000, buries it in 
the ground. Another, having earned and saved $10,000, spends 
it on a great banquet. Which makes the greater demand for 
products ? 

Explain. 

7. Would we naturally expect events like the San Fran- 
cisco earthquake and fire to increase the demand for labor in 
general? 

Explain. 



PRINCIPLES OF TRADE 187 

8. "Economically it is for the interest of every class of 
producers to see the efficiency of other classes of producers in- 
crease." 

Why? 

9. "The extraordinary advance in industrial technique 
characteristic of the last half century has so increased our 
productive capacity that, when things are running smoothly, 
output is bound, sooner or later, to exceed demand, which 
condition of things invariably leads to a commercial crisis fol- 
lowed by a general collapse of industry." 

Criticise. 

10. The Chicago Record-Herald for April 18, 1908, con- 
tained the report of an interview with the head of one of 
America's great universities, wherein various opinions and 
statements were attributed to King Haakon of Norway. 
Among these was the following : "I could black my own boots 
if I wished to ; I have done it and therefore know how ; but if 
I did, what would become of the people who make a living 
blacking boots?" 

Criticise on the basis of Say's law. 

Section B. The Principle of Reciprocity 

If a person were told that he could derive no benefit from 
trade with his fellows unless he bought as well as sold, he 
would perhaps be very impatient at being taken for a person 
so stupid as to need such instruction. As between individuals, 
he would admit, trade is necessarily reciprocal; it is simply 
impossible for the shoemaker to sell his shoes to the wheat 
farmer without at the same time buying the farmer's wheat, 
because the farmer can "demand" or buy shoes only with the 
wheat which constitutes his own product. 

But, when questions of trade between communities arise 
this same man will probably show himself wholly oblivious of 
the principle which seems so evident in domestic trade. He 
will consider it possible, as well as highly desirable, to increase 
the volume of goods sold to other countries while leaving sta- 
tionary the quantity bought, or will bemoan the importation 



1 88 PRINCIPLES OF ECONOMICS 

of goods from outside as decreasing the demand for home 
goods. In point of fact, it is neither desirable nor possible for 
any country to sell more than it buys ; nor, on the other hand, 
is there, in the long run, any danger of reducing the demand 
for, and production of, home goods by the purchase of goods 
from outside. These facts, so often overlooked, so frequently 
the subject of mistaken legislation, are the essence of the Prin- 
ciple of Reciprocity, which we must now explain and estab- 
lish.* 

Broadly speaking, then, the goods exports (actual com- 
modities, not including money, the medium of exchange) and 
the goods imports of that country, must be equal. It will be 
easiest to establish this fact by means of two different propo- 
sitions, (i) that the total exports, including money, and the 
total imports, including money, must be equal, and (2) that 
the total exports, excluding money except as this is conceived 
as a mere metal product, and the total goods imports, exclud- 
ing money except as this is conceived as a mere metal prod- 
uct, must in the long run be equal. 

I. Assuming that no one is cheated, the total exports of 
a country, including money, must equal the total imports of 
that country, including money. 

To begin, we shall take for illustration the commerce be- 
tween the United States and England. Let us say for sim- 
plicity that the exports of the United States to England con- 
sist of meat, cotton, and wheat, and that the imports from 
England consist of textiles and machinery. These are the 



* The Principle of Reciprocity here laid down should not be con- 
fused with the policy of reciprocity much advocated and occasionally 
practiced in this country. The latter, as indicated, is a policy in the 
conduct of a nation's commercial relations, not a natural law govern- 
ing phenomena. Further, as a policy reciprocity has its chief theoretic 
basis in alleged natural laws which are quite inconsistent with the 
Principle of Reciprocity. Most advocates of the policy of reciproc- 
ity are more or less pronounced disbelievers in the Principle of Reci- 
procity. 



PRINCIPLES OF TRADE 189 

products which would ordinarily be called exports and im- 
ports, the products which are reported by the customs author- 
ities. But do these exports and imports exactly balance? Far 
from it. An examination of the custom house records for 
any stated period would show a large discrepancy between 
them, and one which, in our case, is almost certainly in favor 
of the exports. Of commodities that pass through the cus- 
tom house, America exports to England more than she im- 
ports from England. But the matter does not end here. Cus- 
toms reports do not, and can not, show all exports and im- 
ports. The true imports of the United States from England 
include everything bought by its people from the people of 
England. But some things bought from England can not, or 
at least do not, come to the knowledge of government officials. 
Of these the most important are (i) goods and services 
bought from the foreigner in his own country, by our people 
traveling there, (2) the services of foreign capital invested in 
American industries, and (3) services bought from the for- 
eigner, for example, ocean transportation, and delivered in our 
own country, but not appearing in import lists because as serv- 
ices they do not go through the custom house. In short, there 
are invisible, as well as visible, imports ; and it is the sum of 
both of these which must be equal to the total of exports. 
What has been said of imports applies of course to exports. 
Of these, some are visible, some invisible; and it is their sum 
which must equal the total imports. 

Included among our invisible exports would perhaps be a 
quantity of money metal. The United States, as one of the 
chief gold producers, accumulates more of this metal than 
she can profitably use as a domestic circulating medium, and 
accordingly she ships it abroad as one of her products in pay- 
ment for foreign products, just as she ships her meat, hides, 
and steel. This gold is, however, usually exported in the 
shape of money, is not counted by customs officials, and hence 
forms one of our invisible exports. 



igo 



PRINCIPLES OF ECONOMICS 



But, now, even after the invisible imports and exports 
are added to the visible ones, America's imports from Eng- 
land by no means equal her exports to England. // therefore 
the United States were trading with no other country than 
England, the latter country would be compelled, in order to 
equalize the exports and imports, to send us a quantity of 
value embodied in her circulating medium, the money which 
she has coined for, and needs for, her domestic use. This re- 
sult is plainly inevitable. We surely would not give without 
receiving. We should expect to receive exactly as much as 
we gave, and, if we failed to obtain the equivalent of our 
goods in any other form, we would surely get it in the form of 
money. By this device, the exports from the United States to 
England and the imports of the United States from England 
would be made equal. 

Thus far we have shown that, on the hypothesis of inter- 
national trade with a single country, England, our exports 
and imports would be equal. In point of fact, no such equali- 
ty can actually be discovered in the two sides of our trade 
with England or with any other single country. But neither 
is our international trade confined to England or any other 
single country. Hence it is not necessary under the princi- 
ple that our trade relations with any single country should 
balance. The principle states that America's exports and im- 
ports — the total exports and imports hetiveen America and all 
other countries, are equal. If our trading neighbors are not 
one but many, we need only show a complete reciprocity be- 
tween ourselves and the many taken together. This can best 
be done by merely going forward from the point reached un- 
der the simpler hypothesis above. 

The two sides of our trade with a single country do not 
balance. For example, we cannot buy from England enough 
to offset our sales to her, because we have relatively small 
need for her products. But the adjustment from our stand- 
point is easily made. We need to buy extensively from South 



PRINCIPLES OF TRADE 191 

America, the East Indies, and various other countries, while 
having Httle to sell them, and by balancing our excess of im- 
ports from these countries against our excess of exports to 
England, our total imports become equal to our total exports. 

Further, under these new conditions another important 
fact appears. The money which we would have had to take 
from England, as our only trading neighbor, in order to bal- 
ance the imports and exports, is no longer under any necessity 
of moving. For it so happens that, while we need to buy ex- 
tensively from South America, the East Indies, etc., at a time 
when we can sell them but little, England, on the contrary, 
buys from those countries much less than she sells to them. 
The countries named thus become indebted to England in ex- 
actly the same way that she becomes indebted to us. Hence 
England does not send us money out of her own circulation, 
but, using the well developed mechanism of international 
trade, simply transfers to us her credits on South America, 
etc. — that is, allows us to collect her debts in South America 
and other countries. And this arrangement is of course very 
fortunate for us, too, because we collect these debts in the 
form of excess imports from South America, etc., and arj 
thus spared the necessity of sending our own money to those 
countries to make up the deficit in our goods exports to them. 
In short, we will buy international credits from all debtor 
countries, and sell credits to all creditor countries in this way 
just as long as we can; and, if our credits and debits from all 
other countries, for actual commodities, come to a balance, 
there will probably be no movement of money. 

Nevertheless, it may so happen, for a brief period at least, 
that our total goods exports to all countries and our total 
goods imports from all countries are not equal. In this event, 
the deficit, on whichever side it rests, will be made up by an 
export of value in the shape of money, a part of the domestic 
circulating medium. That this must be so is surely self-evi- 
dent. If, taking them all together, the other countries of the 



192 PRINCIPLES OF ECONOMICS 

world are indebted to us and cannot pay in goods, we will 
insist before long on having their money. If we are indebted 
to the other countries, taking them altogether, and cannot pay 
in goods, they will likewise demand our money. Thus by an 
export of money if we have a goods indebtedness to others, 
and by an import of money if they have a goods indebtedness 
to us, our total exports and total imports will be made equal. 

2. The total goods exports of a country (excluding 
money) and the total goods imports of that country, (exclud- 
ing money) must in the long run be equal. 

We have shown in the preceding pages that the total ex- 
ports and imports of a country will be equal if we allow them 
to be balanced by a movement of money. We now assert a 
proposition more advanced and radical : in the long run, the 
equality of exports and imports which is obviously necessary 
will not be — cannot be — secured by movements of the existing 
money stock. If we increase our import of goods, we must, 
broadly speaking, increase our export of goods, not our ex- 
port of money; and vice versa. 

It seems almost justifiable to say that this statement is self- 
evident. A community could not long pay for an excess of 
imports by drawing on its stock of money; since that stock 
would sooner or later become completely exhausted and so 
trade would have to cease. But this exhaustion of the money 
stock is just what amateur economists so generally fear, and 
its appearance, together with the consequent cessation of 
trade, would decisively disprove the Reciprocity doctrine. It 
therefore is necessary to show that there is no danger of ex- 
hausting the money stock through trade or even of drawing it 
down to unduly small proportions. 

In the first place, under normal conditions, international 
trade is mediated through credit rather than through money, 
and, under the natural working of the principles of credit ex- 
change, goods exports and goods imports tend to be made 
equal automatically. The first part of this statement hardly 



PRINCIPLES OP TRADE 193 

needs comment. We have noted earlier that the exporter takes 
his pay in the shape of a credit on other countries and that 
these credits, getting into the hands of exchange dealers, are 
as far as possible cancelled and only balances paid in money. 
Such has always been the practice and, for manifest reasons 
of convenience, always will be. The second part of the state- 
ment, if less familiar, is no less true. Under the natural work- 
ing of credit exchange, exports and imports tend to become 
equal automatically, the balances which have to be paid in 
money tend to disappear or to reach a negligible minimum. 
How this comes about is easily shown. 

Foreign credit, — the medium of exchange in foreign trade 
— is regularly bought and sold, and so has a price known as 
the rate of exchange. This price will be high in any country 
if importing into that country is excessive and exporting de- 
ficient, because the demand for such exchange will be great 
and the supply small ; while, under the opposite conditions, 
the price of exchange will be low. But a high price for ex- 
change will make exporting more, and importing less, profit- 
able than usual, while a low price of exchange will make ex- 
porting less, and importing more, profitable than usual, That 
is, a high rate of exchange will stimulate exports and discour- 
age imports, while a low rate will have an opposite effect. But 
it was excess of imports which caused a high exchange rate ; 
hence excess of imports will tend automatically to increase ex- 
ports and diminish imports. So, it was excess of exports 
which made the exchange rate low ; hence excess of exports 
will tend automatically to increase imports and diminish ex- 
ports. And obviously these tendencies will persist in greater 
or less power until exports and imports become equal. So 
long as either buying from, outsiders or selling to outsiders is 
in excess of the other, a rate of exchange is hound to obtain 
zvhich discourages the side of trade zvhich is in excess and 
stimulates its opposite, with the result that the excess must 
progressively diminish and finally disappear. 



194 PRINCIPLES OF ECONOMICS 

International trade, we thus see, is normally carried on 
without the use of money and tends automatically to balance 
itself without the intervention of money. To lay finally the 
ghost that foreign trade will drain away our stock of money 
— to make clear that the necessary equality of exports and 
imports cannot, under normal conditions, be secured by ex- 
porting our stock of money but must be brought about through 
increasing the export of goods — we need to show that any 
drain from the normal money stock of a country tends to he 
checked automatically. The demonstration is not difficult. 

First, practically all the money exported from any country 
in the course of trade is taken from the bank reserves of the 
chief commercial and banking center, — in our case New York, 
in that of England, London, and so on. The explanation of 
this strict localization of a money drain has already been an- 
ticipated. Trade with outside people is, as we remember, al- 
most entirely carried on with credit ; and the international 
claims thus created get into the hands of a few exchange 
houses in the different countries, are as far as possible can- 
celled, and the balances either way paid in money. But iiievi- 
tably this dealing in, and settling of, international credits is 
mostly confined to the chief commercial center where the large 
volume of transactions develops the most efficient processes of 
settlement. The exchange houses of this commercial center 
of course keep accounts with the banks in the same city, or are 
themselves engaged in a regular banking business. In either 
case, the money they send out will be taken from the banking 
reserves of the commercial center. More especially, it will be 
taken from that portion of the reserve which alone is so free 
as to be fully available, the portion known as the surplus re- 
serve, which is in excess of the amount banks are by law re- 
quired to keep. 

Now, with regard to this banking reserve from which ex- 
port money must inevitably be drawn, two or three significant 
facts should be noted. First, it is, in a very important sense. 



PRINCIPLES OF TRADE 195 

the reserve, not only of the city where it is located, but also of 
the country at large ; for the banks of other cities keep from 
one-half to three-fifths of their reserve in the central city 
banks. Secondly, as a result of the large number and scale 
of transactions, the enormous amount of speculation, and the 
stupendous projects which have to be financed — provided with 
ready money — at this center, the banking surplus or free re- 
serve of the central city is ordinarily kept down to a very low 
point. If business and speculation are very active, the reserve 
is even likely to disappear altogether and be turned into a de- 
ficit. On account of these peculiarities of the central city re- 
serve, changes in its amount are of great significance, and are 
carefully, even anxiously, watched by the business communi- 
ty both of the central city and of the country at large. For 
one thing — and the point of most importance here — these 
changes quickly lead to opposite changes in the rate of dis- 
count, the rate of interest paid on bank loans ; a fall of a few 
millions in the bank reserve sometimes causes the rate on 
call loans to jump from two or three per cent to five or ten or 
fifteen. 

The banking reserve in question thus occupies a very sig- 
nificant place in a country's life, and any considerable change 
in its volume is likely to bring marked results. But, as we saw 
above, money for export is inevitably drawn from this banking 
reserve and may of course very quickly make an enormous 
change in its volume. It should be easy to see then how a 
drain of money from the country tends to be checked. The 
result is accomplished through one or more of several series 
of reactions started by the outflow of money itself. 

The first series of reactions, and the one which works most 
promptly, is as follows : the outflow of money lowers the cen- 
tral city reserve to an abnormal point ; this raises the rate of 
discount ; the central city becomes a more than usually profita- 
ble place for the investment of capital ; this leads foreign cred- 
itors to decide to leave their money capital here for investment 



196 PRINCIPLES OP ECONOMICS 

rather than having it sent to them ; and so the outward ^move- 
ment of money tends to be checked. 

If these first reactions fail, a second series will before long 
inevitably come into play. First, the outflow lowers the cen- 
tral reserve, thus lowering the rate of discount. Second, a 
fall takes place in the price of securities and the gteat staples 
such as wheat and cotton. This grows out of the fact that 
there is a vast amount of speculative trading in these securi- 
ties and staples and the further fact that such trading is large- 
ly based on borrowed capital. As a result, a high rate of dis- 
count hinders people from buying as freely as otherwise and 
even drives them to sell their present holdings, — either of 
which courses tends to lower prices. Third, the fall in prices 
stimulates foreign buying of these securities and staples. And, 
finally, such buying tends to turn the balance of international 
credit in our favor and so to stop the outflow of money or 
even to cause an inflow. 

In extreme cases, a still more powerful series of reactions 
may be set in operation. The outflow of money may go so 
far as to cause a serious deficiency of that instrument for the 
purposes of general trade ; this would tend to bring about a 
general fall of prices ; foreign buying of all sorts of export 
goods would be powerfully stimulated ; and the favorable bal- 
ance of credit quickly resulting would surely stop any money 
outflow. 

Summarizing the discussion, it is plain that any considera- 
ble drain of the ordinary money stock of a country tends au- 
tomatically to check itself ; that, consequently, the necessary 
equality of exports and imports can not in the long run be 
secured by movem.ents of money, (save in so far as these are 
movements of new stocks of money metal) ; and, therefore, 
goods exports and goods imports must, broadly speaking, be 
equal. 

Having established both our first and our second proposi- 
tions, let us now as us.ual condense the results o£ the whole 
discussion in a formal principle. 



PRINCIPLES OF TRADE 197 

Principle. The Principle of Reciprocity 

Exchange between communities, as between individuals, is 
necessarily reciJ>rocal; and, speaking broadly, the total of 
goods (not including money) sold by any community to all 
other communities must in the long run equal the total of 
goods {not iticluding money) bought by that community from 
all others, saive that there will usually tend to be a slight ex- 
cess of -goods exports from communities not producing stand- 
ard money metal and a more or less considerable excess of 
goods imports into a country producing standard money met- 
al — it being assumed that the distribution of population among 
different communities remains substantially unchanged. 

IlIvU STRATI V15 Probi,i;ms 

1. "Another important reason for keeping our fleets as 
far as possible in our own ports is that under this policy the 
money they spend for ordinary supplies goes to our own peo- 
ple." 

Explain what the writer probably meant and criticise it. 

2. "To the same extent that the home market is wrested 
from foreigners and given to protected home producers, the 
foreign market is wrested from unprotected home producers." 
Seager, p. 381. 

Explain and defend the statement. 

3. "When I came to Marblehead they had their houses 
built by country workmen, and their clothes made out of town, 
and supplied themselves with beef and pork from Boston, 
which drained the tozvn of its money." — Barnard's Autobiog- 
raphy. 

Criticise the part in italics. 

4. From a suppositious editorial of a Benton Harbor 
newspaper: "The annual influx of students and other out- 
siders into the fruit belt to engage in fruit picking and pack- 
ing is an abuse which should be stopped at once. These peo- 
ple consume very little, saving their money to take back to Ann 



198 PRINCIPLES OF ECONOMICS 

Arbor, Chicago, and the other places from which they came. 
Thus, while making large sums off us, they give little or noth- 
ing to the support of our industries." 
Criticise. 

5. "One reason for our almost constant excess of exports 
is that we are enterprising and so always opening up new mar- 
kets." 

Objector. "Opening up new markets might increase our 
exports but could not increase our excess of exports unless 
somebody cheated us, — seeing that our country is one of the 
chief producers of gold." 

(a) Argue for the correctness of the second quotation. 

(b) Why was the phrase from the dash, added? 

6. Remarks of a leading Congressman when it was an- 
nounced that the Canal Commission would purchase supplies 
wherever they could be secured most cheaply. "The President 
should be able to see the desirability of purchasing the sup- 
plies in this country alone, because thus employment would be 
given to American capital and labor instead of foreign." 

Explain fallacy. 

7. "The chief reason for our excess of exports is to be 
found in the fact that the things which we sell are more nec- 
essary to our neighbors than the things which they sell are 
to us." 

Criticise. 

8. "The true way to quicken foreign demand (for British 
goods) was to open the ports to that foreign supply with 
which they paid us for what they bought from us." — Morley's 
Gladstone, vol. i, p. 267. 

Show that the above is sound doctrine. 

9. "If we buy rails from England, we get the rails of 
course, but they get our money; while, if we buy the rails at 
home, we have the rails and the money, too." 

(a) Is there any reason to expect that our buying rails 
in England would carry off our regular stock of money? Ex- 
plain. 

(b) Substitute "cotton" for "money" throughout the 
above quotation and show the fallaciousness of the doctrine. 



PRINCIPLES OF TRADE 199 

10. "The trade of the United States shows an excess of 
exports, because it is a large resourceful country which has 
to supply other countries with raw materials." 

Criticise. 

11. "I have always believed that free trade would secure 
the greatest general prosperity, provided that all countries 
would practice it. But, if neighboring countries are bound 
to maintain protection, it is only fair to ourselves to do the 
same." 

(a) What is the real economic evil of having our neigh- 
bors shut out our goods? 

(b) Would we better matters by shutting out theirs? 

12. A Detroit physician who has a son in the University 
at Ann Arbor requires the latter to buy his clothes and other 
supplies just as far as possible in Detroit, on the ground that, 
since his income is earned in that city, it ought to be spent 
there. 

(a) Has the father placed himself under obligations to 
the people of Detroit by earning an income from them? 

(b) Supposing the distribution of population unchanged, 
would Detroit as a whole get any more employment on the 
one plan than on the other? 

13. A Western newspaper, anxious to hinder the people 
of the community from buying outside, represents a silver 
dollar as appealing to a home dentist about to send it to Mont- 
gomery Ward & Co. of Chicago, in the following strain : 

"Now, look here. Doc. If you'll only let me stay in this 
town I'll circulate around and do you lots of good. You buy 
a big beef steak with me, and the butcher will buy groceries, 
and the grocer will buy dry goods, and the dry goods mer- 
chant will pay his doctor bill with me, and the doctor will 
spend me with a farmer for oats to feed his buggy horse, and 
the farmer will buy fresh beef from the butcher, and the 
butcher will come around to you and get his tooth mended. In 
the long run, you see, I will be more useful to you here at 
home than if you send me away forever." 

(a) Clear up once more the fundamental errors in all 
talk of this kind. 



200 



PRINCIPLBS OP ECONOMICS 



(b) Show that, even if we admit the principle implied in 
the quotation (that only the money spent at home can com- 
plete the circuit so as to get back to the original spender), 
only a very small portion of the dollar could get back to the 
dentist. 

14. English people own much capital which is earning in- 
terest or dividends in other countries. What effect does this 
fact tend to have on England's exports or imports? 

15. "If it were possible for one county to provide by law 
or otherwise that no dollar which came into it could be sent 
out, within two years the county would be so much richer 
than its neighbors that they would begin to wonder, etc." — 
Western newspaper. 

(a) What do you suppose are his reasons for expecting 
such a policy to produce the great prosperity predicted? 

(b) Show that his great expectations are unreasonable. 

(c) Show that the policy in question would be likely to 
make the county poorer rather than richer. 

16. "You admit that it would increase the productive 
power of a given county to have a man with one hundred 
thousand dollars move in, bringing his money with him. How, 
then, can you deny that the county would grow richer if it 
could and should for three or four years stop all money which 
came in from going out?" 

Show that we are guilty of no inconsistency in admitting 
the one contention and denying the other. 

17. The following was taken from a country newspaper 
in 1908: "It appears to this paper that all this severe criticism 
* * * of Mrs. Howard Gould's requiring $70,000 a year to 
pay her expenses is quite uncalled for. What's the difference, 
anyway? If she and her folks have the 'dough,' let them 
spend it as fast as they like. That's better than hoarding it. 
When the money is spent it goes to some one and gets into cir- 
culation. We people whom circumstances compel to live on 
30 cents a day would be glad to see all the old millionaires 
spending each $70,000 a year on himself, or ten times that 
amount if he wants to. The money isn't lost." 



PRINCIPLES OF TRADE 201 

(a) State clearly what advantage the writer of the above 
probably imagined that the public derive from the extrava- 
gance of Mrs. Gould and other rich people. 

(b) Explain the fallacy in the doctrine. 

(c) Show that the last sentence of the quotation is of no 
significance in the matter. 

18. "The so-called Principle of Reciprocity is all rubbish. 
It is child's play to show that we can sell to other countries 
even if we do not buy from those countries. No British buy- 
er of American goods asks the question whether America buys 
British goods ? His only question is : 'Does this article in char- 
acter and price suit me ?' if so, he buys it. Further, it is a matter 
of common knowledge that a country will often buy a great deal 
from some other country, even though it sells little or nothing 
to that other country. Thus Germany has no better customer 
than England, whose goods she keeps out by tariff. So we 
buy largely from Brazil, though we sell her very little." 

(a) State the Principle of Reciprocity. 

(b) Show that the arguments against this principle con- 
tained in the above quotation have no bearing on the case. 

19. "Our neglect of the South American trade is simply 
scandalous. We buy a large amount from Brazil every year 
but sell her almost nothing, leaving her markets to be gobbled 
up by England and other European countries. We ought to 
subsidize a great merchant marine running to South Ameri- 
ca, and drive Europe out of a market which is naturally ours." 

Show that a very plausible argument can be made for the 
contention that we should be cutting off our own noses if we 
were to drive Europe out of the markets of South America. 

Section C. The Law of Comparative Costs 

A third fundamental principle of trade tries to answer the 
question: What condition must be fulfilled to make it worth 
our while to cooperate with our neighbors, individual or na- 
tional, by engaging in trade with them ? The economist would 
very likely affirm that there is really no necessity of answer- 
ing the question in any other than the common sense way. It 
is worth our while to trade with other communities when 



202 PRINCIPLES OF ECONOMICS 

and only when their prices make it profitable to do so. "We 
can go deeper," he might say, "but we do not need to. There 
is no better index to the fulfilment of the deeper conditions 
necessary to make exchange-co-operation profitable than that 
given by comparative prices." 

This solution of our problem, however, meets serious dif- 
ficulties. A great many people are convinced on personal 
grounds that it is not a good thing to have trade go just where 
it naturally would in view of price conditions ; they usually 
want to shut out some goods which, if we had regard only 
for prices, we would naturally buy from other people. They 
find no difficulty, either, in adducing excellent reasons, of a 
political and social sort, why we should do this. But, in or- 
der to bolster up their cause they usually bring forward ar- 
guments which they believe to be based on fundamental eco- 
nomic principles. They try to seek out some reason lying 
behind the surface fact of a favorable price, and this rea- 
son usually concerns our ability to produce for ourselves the 
thing we buy as well as, or better than, the country from 
which we buy it. If we can produce it more easily than the 
other people, we have a sure case for the wisdom of producing 
it ourselves. If we can produce it just as easily as the other 
people, the same conclusion is almost as certain. Even if we 
cannot produce it as easily but can only just produce it, 
many people are disposed to declare that we ought not to 
buy it from others. But these ideas are in part at least er- 
roneous, and so the economist is driven to make the deeper 
analysis which would otherwise seem unnecessary. 

One general condition requisite to profitable trade be- 
tween two countries would surely be realized if each country 
is able to produce a commodity more cheaply than the other 
country produces that commodity — meaning, by more cheap- 
ly, with smaller expenditure of real cost, labor, waiting, ulti- 
mate resources, etc. Thus, let us suppose that iron is pro- 
duced in country A at a cost of 25 days' labor (letting labor 
represent all real costs) ; while the same amount of iron costs 



PRINCIPLES OF TRADE 



203 



16 days' labor in country B. On the other hand, a yard of 
broadcloth costs in country A 3 days' labor and in country B 
5 days'. Assuming that the significance or value of a day's 
labor is the same in both countries, then evidently both coun- 
tries would gain if A should produce cloth for both, and B 
should produce iron for both. 

On the basis of this illustration we may say that exchange 
will usually pay, if each of the exchanging countries can pro- 
duce some particular thing much more cheaply than the other ; 
and very likely the most important cases of profitable trade 
would be covered by saying that, when a country is absolutely 
superior to its neighbors in producing the goods it exports and 
is absolutely inferior in producing the goods it imports, such 
export and import is profitable. 

But as was shown long ago by a fuller analysis, this state- 
ment does not cover all cases, and is in fact misleading. If 
we stopped here the reader might very naturally conclude 
that trade would pay only when the condition just explained 
was present, and that we ought never to buy a thing from 
other countries if we could produce that thing as cheai^ly as 
those other countries. 

The unsoundness of the doctrine as applied to an individ- 
ual is at once evident. Here, for example, is a lawyer who 
very likely can mow his lawn, cultivate his garden, and take 
care of his furnace much better than the person or persons 
whom he hires to do these things. Nevertheless, he devotes 
himself to the practice of his profession, and buys the services 
named from other people. And he of course acts wisely in 
doing so, for it is plain that he gains most by using his whole 
time and energy on the kind of work for which he is best 
fitted. He is not interested in the fitness or unfitness of his 
neighbor as compared with himself, but rather in the degree 
in which his own fitness in one line is greater than his fitness 
in another line. So long as can find a market for his possi- 
ble output, he would better devote his time entirely to doing 
the kind of work for which he is preeminently fitted, and get 



204 PRINCIPLES OP ECONOMICS 

his supplies of other things from his neighbors, even though 
he can make those other things better than his neighbors. 

What the lawyer cares about is not whether he can pro- 
duce the thing he buys less cheaply than the man from whom 
he buys it, but whether he can produce that thing which he 
himself sells more cheaply than he can produce the thing 
which it will buy for him. In other words, what is the cheap- 
est way for him to get shoes — to produce them himself or to 
produce legal services, sell these, and use the proceeds to buy 
shoes? It is his comparative efficiency in the two directions 
which determines his conduct. Put in another way, it is the 
comparative cost to himself of producing the two different 
commodities which determines whether he shall produce a giv- 
en one or buy it. He naturally chooses to produce the one 
which has the lower cost to himself. 

Now, a community or nation is in this respect no different 
from an individual. England, let us say, produces principally 
cloth, getting most other goods through exchange with out- 
side communities. England is really better fitted to produce 
some of the things she buys than are the people who actually 
do produce them, and she is, moreover, perfectly well aware 
of the fact. But, like our lawyer, England, though superior 
to other countries in many respects, confines her productive 
efforts to the industry or industries wherein she is most supe- 
rior. The condition which makes her desire to trade is not a 
certain ratio between her own efficiency and that of other 
countries, but rather a certain ratio between her own efficiency 
in one industry — put in terms of cost — and her own efficien- 
cy — put in terms of cost — in other industries. 

But this alone would not make possible trade between 
England and other countries. These countries must also have 
a motive for wanting to trade. How is this possible? Eng- 
land, we have assumed, is superior all along the line; hence 
China must be assumed to be inferior all along the line. It 
is inferior in cloth, inferior in iron, inferior in potatoes. But 
while England, being universally superior, has a motive for 



PRINCIPLES OP TRADE 205 

trading, we must now find a motive for China, in spite of the 
fact that it is universally inferior. 

Though not so evident on the surface, this problem easily 
clears itself up on a little reflection. If China is inferior to 
England in respect to both cloth and iron, she will surely find 
an advantage in specializing where her inferiority is less. If 
she is three-fourths as efficient in producing iron, and only 
one-half as efficient in producing cloth, it will pay her to pro- 
duce iron and buy cloth. Here again the matter which the 
country is interested in is, not the cost of each commodity at 
home, as compared with the cost abroad, but the comparative 
cost at home of the two commodities. 

Thus, both the country universally superior in produc- 
tion, and the one universally inferior, might have adequate 
motive for resorting to exchange. Before exchange could 
actually take place, of course, the particular exchange that is 
desirable for one country would have to be the same that is 
desirable for the other. The differences in comparative effi- 
ciency should be complemental to each other. If England is 
more efficient in the production of cloth than in the production 
of iron, while China is more efficient in the production of 
iron than in that of cloth, then it will be feasible for them to 
effect the specialization which would naturally be profitable to 
them; for the greater superiority of the one just fits the smaller 
inferiority of the other. By using its cloth to buy iron, Eng- 
land takes advantage of its greater superiority; while, by us- 
ing iron to buy cloth, China takes advantage of its lesser in- 
feriority. 

The principle which embodies the essential points brought 
out above has long been known as the Law of Comparative 
Costs. It may be formally stated as follows : 

Broadly speaking, in order to make the exchange of two 
commodities between two countries profitable it is only neces- 
sary that the comparative cost of the commodity exported by 
either of the two countries should be less in that coimtry than 
in the importing country. 



2o6 PRINCIPLES OF ECONOMICS 

The argument for this principle has perhaps been devel- 
oped as fully as is necessary or desirable in the explanation 
leading up to its statement. However, it may be well to give it 
a little more definiteness by the use of an illustration. Accord- 
ingly, let us make two hypotheses in one of which the abso- 
lute cost of the commodity exported by either country is less 
in that country; while in the other hypothesis, this is true 
only of the comparative cost. For the first hypothesis, let us 
suppose that the cost of iron in England is 25 days' labor 
(labor being taken to represent all costs throughout our il- 
lustration), while its cost is only 16 days' in America; and 
that the cost of cloth per yard is only 5 days' in England, 
while it is 6 days' in America. For the second hypothesis, we 
will suppose that costs are the same as before except for 
that of cloth in America which we will assume to be 4 days'. 

Under the first of these hypotheses, the absolute cost of 
iron is less in America, 16 days' to 25 ; while that of cloth is 
less in England, 5 days' to 6. Under the second hypothesis, 
on the contrary, the absolute cost of both iron and cloth is 
less in America than in England, 16 to 25 in the first case 
and 4 to 5 in the second. But, while the two hypotheses show 
different conditions in respect to absolute cost, they are alike 
in respect to comparative costs. Each makes the comparative 
cost of iron less in America, that of cloth less in England. 
Thus, the comparative cost of iron — its cost measured in that 
of cloth — is 16/4 or 4 units in America, and 25/5 or 5 units in 
England. On the other hand, the comparative cost of cloth — 
its cost measured in that of iron is 5/25 or 1/5 of a unit in 
England, while it is 4/16 or 1/4 of a unit in America. Our 
principle tells us that this condition, a smaller comparative 
cost for one of the two commodities in each of the countries, 
is usually sufficient to make the exchange of those products 
profitable. 

The real reason why such a condition will make the ex- 
change of English cloth for American iron profitable, in the 
business sense, builds on a principle of price belonging to a 



PRINCIPLES OP TRADE 207 

later part of our subject ; but that principle is sufficiently fa- 
miliar to every one for our present need. It tells us that there 
must be a rough proportion between the prices of goods and 
their cost : iron costing five times as much as cloth must be 
worth on the market five times as much, while iron costing 
only four times as much as cloth will be worth only four 
times as much. It follows that in the American market it will 
take the proceeds of only four yards of cloth to buy a ton of 
iron, whereas on the English market it will take the proceeds 
of five yards to buy the iron. Conversely, in the English mar- 
ket it will take the proceeds of only 1/5 of a ton of iron to 
buy a yard of cloth, whereas in America this will require the 
proceeds of 1/4 of a ton of iron. Under these conditions it 
will surely pay America to exchange iron for cloth and Eng- 
land to exchange cloth for iron, in spite of the fact that the 
cloth costs England more labor than it does America. 

Before leaving this topic one further comment should be 
added. We have all along spoken merely of the reciprocal 
trade of two' countries. As a matter of fact, most interna- 
tional trade is not of any such directly reciprocal character — 
it is triangular, or multi-angular. England sells cloth to Bra- 
zil; Brazil sells beef and hides to America; America sells 
cotton and iron to England. At bottom, however, although a 
complete demonstration of the fact might prove very diffi- 
cult, the cases of reciprocal and multi-angular trade are sub- 
stantially the same. The condition which makes specializa- 
tion and exchange profitable is a difference between the com- 
parative real costs to one country of the things exchanged 
and their comparative real costs to other countries. 

IlIvUSTrattve Problems 

I. Country A can produce pig iron at a cost of 10 days' 
labor per ton and broadcloth at a cost of 5 days' labor per 
yard. Country B can produce the iron at a cost of 14 days' 
labor and the cloth at a cost of 6 days' labor. 



2o8 PRINCIPLES OF ECONOMICS 

(a) What, in this example, are the comparative costs 
which our principle tells us must be unequal to make exchange 
pay? 

(b) Prove in detail that, if transportation and all costs 
other than labor be ignored, exchange of these two products 
will pay. 

(c) Which commodity will country A export? 

2. Make a hypothetical case yourself and prove with it 
that exchange will not pay if comparative costs are equal. 

3. "We may often by trading with foreigners, obtain 
their commodities at a smaller expense of labor and capital 
than they cost the foreigners themselves." — Sumner. 

(a) Show with illustration that this is true. 

(b) Show how such a trade could be profitable to the 
foreigner. 

(c) What do you suppose is the ultimate cause which 
explains the fact that such trade can be profitable? 

4. "We know that England can make ships more cheaply 
than we can, and so we should let her do the ship building 
and turn our capital to such things as we can do better than 
she can." Assuming the conclusion — that we should turn our 
capital to other things — to be correct, the reason given for it 
is not entirely satisfactory. Explain. 



CHAPTER XIV 

PRICE : PRELIMINARY 

We have already more than once emphasized the point 
that, in the present economic order, exchange is the factor 
which effects — makes possible — the co-operation of men in 
their economic efforts and, what is equally important, regu- 
lates or directs that co-operation. As we have also noted, 
the chief process whereby exchange accomplishes the regu- 
lation is moving prices up or down. For example, if too 
little of any particular thing is produced, exchange presently 
gives us a higher price, which higher price makes the produc- 
ing of the thing in question more profitable and so causes 
more to be produced. Again, exchange regulates the utilisa- 
tion of the stock already in existence, through changes in 
price. Thus, if the stock of any commodity is exceptionally 
small, the price rises, people curtail their consumption and 
thereby the abnormally small stock is made to go around. 
Finally, exchange regulates how wealth shall be distributed, — 
how much each person shall receive in wages, rent, interest, or 
profits, chiefly by this same process of moving prices up or 
down. From these facts, it is manifest that the processes of 
price-determination are, in the present order, of paramount 
importance, and that the natural laws which regulate these 
processes form a very vital part of the science of economics. 
We now enter upon the study of those laws. In the present 
chapter, we shall confine ourselves to the task of clearing the 
ground for our study, defining the more important concepts 
involved, setting forth the conditions assumed, and explain- 
ing the two principal forces at work. 



2IO PRINCIPLES OF ECONOMICS 

Section A. Some Definitions 

I. Prices 

By price the economist means the sum of money at which 
a seller is ready to dispose of his wares or the one at which 
a buyer is ready to purchase or the one at which an exchange 
actually takes place. That is, a price has to do with an actual 
transaction of exchange contemplated or consummated. Here- 
in it differs from pecuniary value in general ; since the latter 
may be a price which persons think a commodity would or 
ought to command. A further mark of price is that it is 
concerned with a single conventional tmit of the commodity, 
not with an aggregate. We speak of the price of a bushel of 
wheat, but not of the price of the wheat crop of the United 
States. For this latter purpose, the term value is used, and 
means simply the price multiplied by the total number of 
units. 

2. Market 

A word much used in price discussion is "market." As 
a noun, we mean by this the totality constituted by a group of 
competing sellers over against a group of competing buyers 
concerned in exchanging the same commodity. The one most 
essential condition is the freely competitive character of each 
of the two groups which together constitute the market. All 
the members of the sellers' group are trying to offer their 
wares to all members of the buyers' group; and all members 
of the buyers' group are trying to offer to purchase from all 
members of the sellers' group. 

It should be noted that the definition omits any reference 
to a specific place. Though a market usually has a location, 
the really essential element in it is rather a threefold set of 
relations: (i) those among the sellers, (2) those among the 
buyers, and (3) those between the two groups over against 
each other. If men in Chicago, Detroit, and Duluth are 
freely competing with each other in selling wheat to the same 
general group of buyers, they belong to the same market 



PRICE: PRELIMINARY 211 

though located in widely separated cities. On the other hand, 
two persons living in the same city may belong to different 
markets for the same commodity, provided they are dealing 
with a different group of buyers. This point is best illus- 
trated in the distinction between the jobbers' market and the 
retailers'. Mr. Sanders, a resident of Poughkeepsie, buying 
coffee for family consumption from his grocery, does not be- 
long to the same market as Mr. Forsyth, another resident, who 
imports coffee from Brazil, but chances to reside in Pough- 
keepsie. 

It must of course be admitted that, in a sense, all mar- 
kets concerned with the same commodity — 'importers, jobbers, 
wholesalers — influence one another, and so, in a sense, con- 
stitute one great composite market. The buyers in each mar- 
ket are influenced by the attitude of the buyer group in the 
others ; and so with the sellers. Each buyer in a market ap- 
proaching the primary one is at once a buyer in the latter and 
a seller in some market approaching the consumer's. His at- 
titude as a buyer, the intensity of his competition in the more 
primary market will be more or less determined by the atti- 
tude of buyers in the market where he is a seller. But, after 
all, this close and organic connection between the different 
markets for any commodity must not lead us to overlook the 
essential separateness of those different markets. When the 
same man buys and sells the same commodity in a market 
which is really one, his action is self-destructive, contradic- 
tory.* On the other hand, if any person is both buying and 
selling the same commodity, without involving any inconsis- 
tency, he is really dealing in two markets — the market in 
which he sells is a different market from the one in which he 
buys. 



* This is sometimes done in stock and produce markets, just be- 
cause the two acts neutralize each other. A dealer desiring to hedge, 
to escape the responsibility of an earlier transaction, enters into a neu- 
tralizing one. 



212 



PRINCIPLES OP ECONOMICS 



3. Competition 

In an earlier chapter we made some reference to competi- 
tion, defining it in a general way as the striving for the same 
prizes, the pursuit of the same opportunities, by homogeneous 
units. It is not necessary to repeat any large part of those 
earlier comments; but, in view of the fact that competition 
comes to a focus, so to speak, in the field with which we are 
now concerned, — the determining of prices — it seems desir- 
able to introduce one or two comments here. 

First, let us once more remind ourselves of one of the most 
fundamental features of true competition, namely, that, as 
in all cases of true rivalry, the competing persons must func- 
tion in the same general way. Buyers are competing with 
other buyers, not with sellers ; sellers are competing with other 
sellers, not with buyers. The applicants for a job with the 
Michigan Central Railway Company are competing with one 
another, not with the railway company. So the railway com- 
pany is competing, not with the applicants, but with other 
employers of such types of labor. Doubtless the successful 
applicant and the company will each try to gain some eco- 
nomic advantage at the expense of the other, — the applicant 
to get higher, the company to pay lower, wages than the mar- 
ket justifies. But this antagonistic striving is not competition. 
It belongs rather to another line of action, namely, bargain- 
ing, the process through which seller and buyer come to an 
agreement. 

A second comment with respect to competition which it 
seems desirable to make is that, in a sense, full competition 
on the part of the persons belonging to either group— buyers 
or sellers — really involves some action on the part of the mem- 
bers of the other group. Strictly speaking, the competition 
of sellers is not real, but only seeming, unless every seller 
really gets his bid or offer before every buyer. So the com- 
petition of buyers is only seeming, unless every buyer gets 
his bid or offer before every seller. Since the utmost effort 



PRICB: PRBLIMINARY 213 

on the part of sellers would hardly suffice to get their offers 
before all buyers, unless the latter do something to help in 
the process, we may say that competition can scarcely be 
adequate, completely realized, unless the buyers contribute 
to the result. So, since the utmost probable effort on the 
part of buyers could scarcely suffice to get their bids before 
all sellers, unless the latter do something to help in the process, 
competition on the buyers' side cannot be completely ade- 
quate, unless sellers contribute in some degree to the result. In 
other words, complete competition within either group re- 
quires that there shall be alertness, openness of mind, and 
enterprise in the opposite group. 

A third comment with respect to competition which ought 
to be made concerns its inherent limits. It is a mistake to 
include under this term as used by the economist the policy of 
underselling a competitor at a loss as a means for accom- 
plishing ulterior ends — e. g., driving him out of business, or 
punishing him for some personal injury. The competition of 
the economist is supposed to be directed to the gaining of an 
economic advantage derivable from the opportunity to make 
a particular sale or purchase. This means that, on the one 
hand, the seller will continue to lower his price until he gets 
for his commodity no more than it costs him, but no longer 
than this ; and, on the other hand, that the buyer will continue 
to raise his bid until he pays for the commodity as much 
as it is worth to him, but no longer. It is only on competi- 
tion when understood in this sense, that the principles of price 
to be explained in the following chapters are founded. They 
assume that competition will always cease when the imme- 
diate economic gain is completely eliminated. Cut-throat com- 
petition, predatory competition, to use a term having much 
vogue in recent years, is not included in the competition of 
economic theory. 



214 PRINCIPLES OF ECONOMICS 

Section B. General Conditions Assumed as the Basis of 
Price Doctrines 

Another matter that needs comment as prehminary to our 
study of price-determination concerns the general conditions 
under which the processes involved are supposed to go on. 
The principles of economics, like those of any other science, 
are largely hypothetical. They assert that under certain as- 
sumed conditions Phenomenon A will be accompanied or fol- 
lowed by Phenomenon B ; and conversely, they assert, or 
should be understood to assert, that unless the conditions 
named are present the appearance of the phenomena in the 
relation mentioned will not occur, or at any rate need not be 
expected to occur. It is therefore essential, for a clear com- 
prehension of price doctrines, that we keep in mind just what 
the assumed conditions are. 

We assume, first, that each man taking part in the ex- 
change process is an ideal or perfect economic man. His 
feelings and motives are predominantly, if not wholly, con- 
cerned with getting the maximum of satisfactions for himself, 
and they consistently remain so from day to day and year 
to year, all other motives such as charity and sympathy be- 
ing shut out. The man has also full knowledge of market 
conditions and excellent, not to say perfect judgment in mak- 
ing decisions. And his actions are entirely free of caprice, 
passion, and prejudice, so that he would naturally buy always 
in the cheapest market and sell in the dearest. 

The assumption of a perfect economic man naturally car- 
ries with it the assumption of a perfect market where the 
man's operations are performed. In this market every seller 
is supposed to be successful in putting before every buyer the 
particular opportunity he is ofifering, and every buyer is sup- 
posed to be successful in putting before every seller the op- 
portunity which his desire to purchase creates. The most es- 
sential features of such a market would be, first, extensive 
and efficient means of gaining information and disseminata 



PRICE: PRELIMINARY 



215 



ing it among buyers and sellers, and, second, conditions fav- 
orable for allowing men to act rationally on the information 
received. Finally, this perfect economic man in the perfect 
market is supposed to carry the principle of competition to 
its logical conclusions — to continue competing so long as there 
is a surplus of immediate economic advantage over the sac- 
rifices made, but no longer. 

Now, as every one knows, the ideal conditions described 
are never entirely realized in any actual exchange situation. 
Men are influenced by motives other than the economic, their 
knowledge and judgment are imperfect and their actions in- 
consistent. The perfect market, too, is rarely if ever to be 
found. The great exchanges which provide our nearest ap- 
proach to it, have ample means of disseminating information, 
but they often fall short in other respects because the excite- 
ment, the rumors, the tendency to imitation — these and other 
conditions which flourish among a large number of men gath- 
ered in the same room — cause buyers and sellers to act with- 
out rationality and deliberation. Moreover, we know that 
the pure competition of the economic hypothesis is always 
more or less hampered, and often greatly hampered, by the 
cut-throat tendency on one side and by monopoly on the other. 

But, although these ideal conditions are never entirely real- 
ized, we are compelled, if we wish to make any progress at 
all in our science, to accept them as the fundamental basis of 
our reasoning. The human intellect is of but limited reach 
and power; and in economics, as in any other science, it is 
quite incapable of studying simultaneously all the forces at 
work, or all the varying intensities of even one force. We have 
to study the different forces separately under simplified con- 
ditions by eliminating many elements and assuming a fictitious 
purity and uniformity in those retained. It should be add- 
ed, however, that if this is the only way to make progress, it 
is in economics,, as in other sciences, a perfectly feasible way. 
It enables us first to gain a knowledge of fundamental prin- 
ciples, unconfused by exceptions. When we undertake to ap- 



2i6 PRINCIPLES OF ECONOMICS 

ply the principles in actual life, it may be necessary again to 
take into account the various forces from which our atten- 
tion has been abstracted in the purely economic analysis. But, 
after all, exceptions to the principles are much less important 
than the principles themselves ; and, anyway, we cannot even 
begin to understand the former until the latter come to hold 
an assured place in our minds. However abstract, therefore, 
however dependent upon imperfect or unreal hypotheses, the 
principles constitute the deepest, most vital facts in actual 
price-determination, and so must be fully mastered. 

Section C. Demand 

It is a fact with which almost everyone has some acquaint- 
ance that the determination of price, in any but its most su- 
perficial aspect, is somehow a matter of demand and supply. 
Accordingly, we must now give some attention to these ele- 
ments. The present section will be devoted to a study of de- 
mand. 

I. The Nature of Demand 

By the demand for any commodity, the economist means 
in general the quantity of that commodity which buyers stand 
ready to take at some specific price. In this definition let us 
emphasize, first, the point that demand is the amount which 
buyers stand ready to take, — offer to take. That is, demand 
must not be confused with (a) the amount men want, on the 
one hand, nor (b) with the amount men actually buy, on the 
other. Demand must not be confused with the amount of a 
commodity which men want. Mere want, mere desire, not 
backed by buying power and not brought to an issue in a de- 
cision to purchase if the price is satisfactory, does not consti- 
tute demand. The penniless man looking in at the baker's 
window, however hungry, adds nothing to the demand for 
bread. It is plain, of course, that men's needs, wants and 
plans play a vital role in determining demand. Thus, if an 
electric company is intending to use the water-power of the 



PRICE: PRBUMINARY 217 

Huron river on a great scale for supplying current to Detroit 
and other cities, the company will need a large amount of 
copper wire, and, so, will doubtless come on the market to 
buy such wire. But while needs and plans constitute one 
condition of demand, they do not constitute demand itself. 
Demand exists only when the company stands ready to buy 
the wire, (b) But, if we take care not to confuse demand 
with the amount which people want or need, we must be 
equally careful to distinguish it from the amount actually 
bought. The amount of demand and the amount bought 
will often be equal; but the meaning, the connotation, of the 
two phrases is very different, and this difference is of the 
highest importance. The amount which buyers stand ready 
to take plays a very great part in determining price. But the 
amount actually bought plays no such part, — in fact, is itself 
determined after price is determined. To repeat, demand, in 
our definition, means neither the amount of a commodity 
wanted, nor the amount bought, but the amount which men 
stand ready to buy. 

A second point in our definition which needs emphasis is 
the phrase "at some specific price." Every proper statement 
affirming the existence of a demand must explicitly or by im- 
plication represent this demand as conditioned on a certain 
price. Thus, it is proper to say, "The demand for silver at 
55 cents per ounce is 120,000 ounces." It is not proper to 
say "The demand for silver is 120,000 ounces," leaving out 
the phrase "at 55 cents per ounce," except on condition that 
both the person making the remark and the one to whom 
it is addressed already have one particular price in mind, as 
for example, the price at which sales are actually being made 
at the time the statement appears. The grounds on which 
this contention rests are perhaps sufficiently evident. The af- 
firmation that "the demand for silver is 120,000 ounces," 
strictly interpreted, ought to mean that there is a demand for 
120,000 ounces of silver whatever he the price. But, of course, 



21 8 PRINCIPLES OP ECONOMICS 

no such affirmation could reasonably be made. If any person 
familiar with business matters were to make a statement like 
the above, he would doubtless mean, and other persons would 
understand him to mean, that the demand for 120,000 ounces 
existed at the current market price or at some price approxi- 
mately equal to the market price. 

One further point in explanation. Our definition implies 
that the relation between the volume of demand and the con- 
ditioning price is two fold. It means, first, that if price is the 
one named, the demand will be of the volume indicated, and 
secondly, that, only if price is as low as the one named, will 
demand be of the volume indicated. Accordingly, if we say 
that the demand for silver is 120,000 ounces at 55 cents, we 
should be understood as affirming both the following proposi- 
tions: (a) If any person wishes to insure that demand shall 
not get as large as 120,000 ounces, he must insure that price 
does not go as low as 55 cents, (b) If any person wishes to 
insure that demand shall be as great as 120,000 ounces, he 
must insure that price does go as low as 55 cents. 

2. The Relation of Demand to Price 
In the preceding discussion, it was shown that the quan- 
tity of demand is conditioned upon price. We must now ex- 
plain this conditioning more fully. Let us suppose that, on a 

p 40 8.0 t2D feO 200 2\0 



' Fig.l. 

certain day, the demand for silver at a price of 55 cents is 
just 120,000 ounces as in our last illustration. This quantity is 
represented in the accompanying diagram by the rectangle 
DD', — the vertical scale at the left indicating the price in 
cents and the horizontal scale at the top indicating the num- 



PRICE: PRELIMINARY 



219 



ber of ounces in thousands. Now, starting with this hypothe- 
sis that 120,000 ounces are demanded at 55 cents, we may be 
quite sure that the same persons who stand ready to buy that 
amount at the price stated, or, anyhow, some other persons, are 
ready to buy, — have the mental attitude needed to induce them 



9 , , . ^0 8P '^0 leo 200 240 

« — I — 1 — I — L-J — I — I — I — I — I ■ T ■■■'■ ■< r ... f ■ 




Fig-Z. 



to buy, — say, 10,000 ounces more at a price of 54c; 40,000 
ounces more at a price of 53c ; 80,000 ounces more at a price of 
52c; and so on. That is, right alongside of the 120,000-de- 
mand which would be realized if a price of 55 cents were 
reached, and a part of the same general situation, we have 



-^P. . .^P . ■ .'^^ ■ .'^P. ■ .^9Q-. , /^-^-V 




Fig.5. 



various other potential demands which would just as surely 
be realized if lower prices were established. In Figure 2, we 
have these other demands presented along with demand at the 
55 cent price. 

But, not only is it involved in the demand situation that 
larger amounts would be taken were the price lower than 55 



220 PRINCIPLES OP ECONOMICS 

cents ; the complementary statement is also true. Given the 
present mental attitude of buyers, the amount demanded by 
them would be smaller if price were higher than 55c, instead 
of lower. Thus, some of the people whose offer to buy at 55c 
aggregated 120,000 ounces, would, if price rose to 56c, with- 
draw a part or all of their former demand ; they, or others, 
would withdraw still more of that demand, if price rose to 
57c ; still more, if it rose to 58c ; and so on. That is, as a part 
of the same general situation from which we set out, we have 
a series of potential demands at prices above, as well as at 
prices below, the assumed one of 55c. Supposing these de- 
mands to be 110,000 ounces at 56c, 80,000 ounces at 57c, 40,- 
000 at 58c, and so on, and combining them with the demands 
indicated in our last diagram, we should have the result rep- 
resented in Figure 3. 

We are now prepared to explain the meaning of a phrase 
which will be frequently used in the following pages, — the 
phrase "demand schedule." Demand, as we have just seen, 
is always relative to a particular price stated or implied, and 
the amount of demand, generally speaking, varies inversely 
though not proportionally to price : the lower the price, the 
greater the demand; the higher the price, the smaller the de- 
mand. It follows that the facts of demand at any time re- 
quire for their adequate statement a series of conditional prop- 
ositions. Thus, the supposed case for silver would be most 
adequately stated as follows : — 

The demand would be 40,000 oz. if price were as low as 58c. 

The demand would be 80,000 oz. if, and only if, price were as low as S7c. 

The demand would be 1 10,000 oz. if, and only if, price were as low as 56c. 

The demand would be 120,000 oz. if, and only if, price were as low as 55c. 

The demand would be 130,000 oz. if, and only if, price were as low as 54c. 

The demand would be 160,000 oz. if, and only if, price were as low as 53c. 

The demand would be 200,000 oz. if, and only if, price were as low as 52c. 

Such a series of propositions, we call a demand schedule. In 
order to abridge the statement of it, we will put it in the 



PRICE: PRELIMINARY 



221 



TA. 


BLE I 


Price 


Demand 


cents 


000 02. 


58 


40 


57 


80 


56 


no 


55 


120 


54 


130 


53 


160 


52 


200 



form of two columns of figures with 
the proper headings, Price and De- 
mand, as shown in Table i. The stu- 
dent must always remember, however, 
that it is, in effect, a series of condi- 
tional statements, such as those already- 
given. 

A demand schedule of the general 
type just presented probably comes 
nearer to representing the facts of ex- 
perience than would a more symmetrical one. But as our 
purpose in using these schedules is primarily pedagogical, we 
shall change this one to a form which can be used more ef- 
fectively in clearing up the theory of price. In this new 
schedule, the variations of demand 
consequent upon changes in price are 
represented as uniform, 10,000 ounc- 
es in each instance. Thus altered, 
and carried both higher and lower, 
our schedule will appear as in Table 
2. In diagrammatic form it is pre- 
sented in Figure 5. 

One further point which should 
be noted before we leave this imme- 
diate topic is a possible ambiguity in 
our use of the expressions "demand 
has changed," "variation in demand," 
etc. In one connection, we em- 
ploy this language to mean that demand at a given price 
is now different from what it has been at the same price; in 
another connection to mean that actual demand — no price be- 
ing specified — has changed. Understood in the second sense, 
such statements are relatively unimportant, yet will occasion- 
ally be made. Thus we may have occasion to say that, "on 
account of the sharp advance in wheat yesterday, the demand 



TABLE 2 


Price 


Demand 


cents 


000 oz. 


60 


70 


59 


80 


58 


90 


57 


100 


56 


no 


55 


120 


54 


130 


53 


140 


52 


150 


51 


160 


50 


170 



222 



PRINCIPLES OF ECONOMICS 



for cash wheat for milling purposes fell off greatly." But^ 
when we are interested in the causation of a change in price^ 
we must be careful to exclude this meaning of a "change in 
demand." Such a change is the consequence of a change in 
price, not the cause of that change. As we shall soon learn, 
it is very probable that the sharp rise in price indicated was 
due to a change in demand, — of course a rise, not a fall — ; 
but, if so, the change must have been of the first kind, — the 
demand at the same price must have increased. 
40 80 120 



160 



60 



55 



50 



P/g 5 

In order to avoid the ambiguity just referred to, it might 
be well to use the expression "the demand schedule has ad- 
vanced," when we mean that demand at the same prices has in- 
creased. As we shall see, a general change in the demand 
schedule, not in just one item of demand, is really necessary 
to bring about a change in price; and so this method of ex- 
pression would be more adequate than any other. But it would 
probably be futile to attempt to make such a change in usage. 
We must, therefore, be careful not to confuse the two possi- 
ble meanings of "changes in demand." 



PRICE: PRELIMINARY 223 

Since the points established in the preceding discussion 
are of much importance in later connections, we will give them 
the emphasis derived from definite formulation in a principle. 

Principle. The Law of the Inverse Elasticity of Demand. 

Demand is always relative to a particular price expressed 
or implied, and, broadly speaking, varies inversely as said 
price, though no proportionally. 

3. The Interpretation of Demand Schedules 

As we shall have frequent occasion, during our study of the 
theory of price, to make a discriminating use of demand 
schedules, it is very important that, at the outset, we should 
gain familiarity with the true nature and significance of these 
schedules and their various parts. First, it is to be noted that 
demand at any particular price is a composite made up of many 
sections or increments, each one of which, except the last, 
would appear at some higher price. To clear this up, let us 
start with the lowest line in our demand schedule on page 
221, the demand at 50 cents. Manifestly, this 170,000 ounc- 
es consists of the 10,000 which came in only when price fell 
to 50c, added to the 160,000 already wanted at 51c. But the 
160,000 ounces, in turn, consists of the 10,000 which came in 
at 51c, added to the 150,000 already wanted at 52c. And the 
150,000 ounces, again, is the 10,000 coming in at 52c added to 
the 140,000 wanted at 53c — and so we might continue all the 
way to the top of the schedule. Accordingly, the 170,000 
ounces wanted at 50c is the sum of all the increments of de- 
mand which would successively appear, if price were to pass 
through all stages from the highest to the lowest. This fact 
is graphically presented in Figure 6, where the small letters 
represent the successive additions to demand which are sup- 
posed to appear at each price. Thus, q comes in at 50c itself ; 
p came down from 51c; o, from 52c; n, from 53c; m, from 
54c; /, from 55c; and so on. 

Another important matter concerns the different divisions 



224 



PRINCIPLES OF ECONOMICS 



into which the various sections or increments of demand 
group themselves when any particular price has been estab- 
lished. The first break occurs between the excluded incre- 
ments and the included ones. Thus, if price proves to be 55 
cents, all the increments of demand which depend upon a 
price lower than this will, of course, be shut out; while all 
increments which depend upon this or a higher one will be 



9 4,0 80 I2£ 

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included, for the man who was ready to buy at 56c or 57c or 
58c will surely be in the same frame of mind if price falls 
to 55c. In Figure 7, the included increments of demand are 
represented by the shaded squares, and the price at which each 
comes in is indicated by its position. The excluded increments 
of demand are represented by the unshaded squares. 

A still more useful grouping of the different increments 
divides the included ones into marginal and intra-marginal, 
and distinguishes the excluded ones as extra-marginal. The 
marginal increment of demand is the last of the included 
ones, the last to appear when an actual price of 55c was be- 
ing established.* In Figure 7, it is represented by the lowest 

* For the sake of brevity, we not infrequently say "the marginal 
demand" instead of "the marginal increment of demand." In doing 
this, we must avoid confusing the marginal increment of demand with 
the total demand at the margin, that is, the marginal increment plus 
all the preceding increments. 



PRICB: PRULIMINARY 



225 



of the shaded squares, labeled "Marg;" for this 10,000 ounc- 
es, which would not have been wanted at a price of 60c or 
59c or 58c or anything above 55c, must, plainly, be the last 
addition to demand. This particular increment of demand 
is a most significant one in price-determination ; since the de- 
sire of sellers to bring it out is one of the motives which lead 
them to bid price down to 55 cents. Hence we naturally dis- 



40 



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1^0 



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200 24.0 



60 



55 



50 



luded 




Ejf eluded 



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tinguish all other included sections or increments, all sections 
which are realized even when actual price is as high as 56 
cents, — as being within the margin, and designate them intra- 
marginal increments. On the other hand, the excluded sec- 
tions of demand, the sections or increments which would ap- 
pear only if price fell to figures lower than 55 cents, being 
without the margin, are naturally called extra-marginal in- 
crements. As will later appear, the first among the extra- 
marginal increments of demand is the only one which plays 
a vital role in the immediate determining of prices. 

Now, the marginal increment of demand is the one which 
comes in with that price, among all the prices at which any 



226 PRINCIPLES OF ECONOMICS 

increment of demand comes in, which is the lowest of the 
series. Thus, in Figure 7, with a price of 55 cents, the prices 
at which the included increments of demand come in are 55 
cents, 56 cents, 57 cents, 58 cents, and so on ; and it is the 
lowest of these, 55 cents, at which the last or marginal incre- 
ment of demand comes in. This lowest price of the series, 
viewed as the price on which is conditioned the forth-com- 
ing of the marginal increment of demand, is a concept of 
prime importance in our present study. It will be designated 
the marginal demand price. 

Clear and definite ideas concerning the marginal demand 
price can best be attained by starting with the hypothesis that 
demand remains constant through several changes in price.* 
Such a demand schedule is represented in the accompanying ta- 
ble and Figure 8. There is no addition to demand aif ter 59 cents 
is passed until 53 cents is reached; 
therefore, if actual price were 54 
cents, the marginal demand price 
would be 59 cents, — ^that being the 
price at which the last addition to 
demand was made. This price, 59 
cents, would obviously continue to be 
the marginal demand price, if actual 
price rose to 55 cents or 56 cents or 
57 cents or 58 cents or 59 cents. If, 
however, actual price became 60 
cents, the marginal demand price 
would change to 60 cents; since the 
10,000 ounces which formerly came 
in at 59 cents would no longer be wanted, and so the 10,000 
ounces coming in at 60 cents would be the last increment of 
demand. 



Demand 


Price 


000 oz. 


cents 


50 


62 


60 


61 


70 


60 


80 


59 


80 


58 


80 


57 


80 


56 


80 


55 


80 


54 


90 


53 


100 


52 


no 


51 



*As we shall learn in a later chapter, long-time demand sched- 
ules,— schedules which sum up the demand facts for a whole period— 
often show this peculiarity. 



PRICE: PRELIMINARY 



227 



Under the demand schedule represented in Figure 8, the 
marginal demand price was 59 cents, even though actual price 
was as low as 54 cents. The typical market schedule, how- 
ever, is more Hke that represented in Figure 7, where the 
marginal demand price would necessarily coincide with the 
actual price. The reason is plain. It is assumed that, with 
every fall in price, some addition to demand takes place; 
hence, whatever price in the series became the actual price, 
some portion of the demand would be forthcoming only be- 
cause that particular price was established; and so that price 
would be the marginal demand price as well as the actual 



y , ■ , 1^ ■ , . «p 



\zo 



r , 



LliL 



60- 



55 



5c- 




InTroi 



Ma rginat 



ilji Marginal 




Extra- 
Marginal 



Fig-a. 



price. But even though in the cases chosen as typical, actual 
price and marginal demand price necessarily coincide, the 
other concept is not superfluous or useless. We shall later 
meet long-time schedules wherein these quantities do not co- 
incide ; and, even when they do coincide, they are after all 
essentially different things, — one, the marginal demand price, 
being in part at least the determinant of the other, actual price. 
Another demand price which it is important to distinguish 
is the first extra-marginal one, — the price which would be nec- 
essary to make actual the first extra-marginal increment of 
demand. Under the demand schedule represented in Figure 



228 PRINCIPLBS OF BCONOMICS 

8, the first extra-marginal demand price would be 53 cents, as 
long as actual price was anything from 59 cents down to 54 
cents. If actual price rose to 60 cents, the first extra-mar- 
ginal demand price would be 59 cents. If actual price fell to 
53 cents, the first extra-marginal demand price would be 52 
cents. 

As a matter of course, we often have occasion to apply 
the terms marginal, extra-marginal, and intra-marginal to 
buyers. Marginal buyers are those who make some or all 
of their purchases only when, and because, actual price has 
fallen to the marginal demand price. In other words, the 
marginal buyers are the ones who are responsible for the mar- 
ginal increment of demand. So, the intra-marginal buyers 
are the ones responsible for the intra-marginal increments of 
demand. Their purchases would be assured, even if price 
were higher than it proves to be. The extra-marginal buy- 
ers are the ones responsible for the extra-marginal increments 
of demand. They make no purchases and are frequently 
called the excluded buyers. 

Section C. Supply 

I. The Nature of Supply 

We have considered one of the two most essential ele- 
ments in price-determination, demand; we must now take up 
the second, supply. In general, we shall understand the sup- 
ply of any commodity to mean the quantity of that commodi- 
ty which sellers stand ready to dispose of at some specific 
price. 

Here we need to emphasize, first, the statement that sup- 
ply is the amount which sellers stand ready to dispose of. In 
particular, the supply of anything should not be confused 
either (a) with the total amount in the hands of producers or 
dealers, or (b), on the other hand, with the amount actually 
sold, (a) Supply should not be confused with the total 



PRICE: PliBLIMINARY 229 



228 PRINCIPLES OP ECONOMICS 



INSERT, p. 228 



IivLUSTRATive Problems. 



I. Suppose that the demand schedule for silver at a certain time is 
represented by the accompanying table, and answer the questions which 
follow. 

(a) Interpret the first three lines; the last 
five lines. 

(b) What would be the marginal increment of 
demand if actual price were 67 cents? 65 cents? 
63 cents? 59 cents? 57 cents? 55 cents? 

(c) What would be the first extra-marginal 
increment of demand if actual price were 66 cents? 
65 cents ? 61 cents ? 59 cents ? 54 cents ? 

(d) What would be the marginal demand price 
if actual price were 6y cents ? 66 cents ? 63 cents ? 
60 cents? 56 cents? 52 cents? 

(e) What would be the first extra-marginal de- 
£ '.Sz'S^ IB 3JOIU e loS-S$ :}^ i^ '.Sl'9^ r^ z '.g% ;b 
mand price if the actual price were 65 cents ? 66 
cents ? 67 cents ? 63 cents ? 

(f) Who would be the marginal buyers if 
actual price were 66 cents? 53 cents? 55 cents? 
60 cents? 54 cents? 

(g) Who would be the first extra-marginal 
buyer if actual price were 66 cents? 65 cents? 61 
cents ? 58 cents ? 56 cents ? 52 cents ? 

2. Suppose that on the second Saturday of 
October a section of the demand schedule for 
wood in Ann Arbor is as follows : i cord wanted 

more at $5; 7 more at $4.75; 8 more at $4.50; and so- on. Put it into 

tabular form. 

3. Suppose that the conditions of demand for Milton's autographs are 
such that I would be wanted if the price were $200; 2 if price were $175; 
4 if $150; 5 if $140; 8 if $125; 9 if $110; 12 if $100; 13 if $90; 15 if $75; 
and 20 if $50. Put this demand schedule into tabular form. 

(If the problem had said: i wanted at $200; 2 at $175; and so on, it 
would have meant the same thing.) 



Demand 


Price 


000 oz. 


cents 


66 


68 


70 


67 


70 


66 


70 


65 


84 


64 


92 


63 


100 


62 


100 


61 


100 


60 


100 


59 


107 


58 


120 


57 


120 


56 


120 


55 


133 


54 


145 


53 


145 


52 


156 


51 



PRICE: PRELIMINARY 



229 



amount in the hands of producers or dealers. This total we 
call stock; and only a part of it constitutes supply, — so much 
of it as people stand ready to sell at some price or other. But, 
though stock is not the same as supply, it is of course the 
immediate source of supply, and, therefore, does much in de- 
termining supply. On the one hand, it always sets an up- 
ward limit to supply. On the other hand, it exists only to be- 
come supply, and so must ultimately make supply as large 
as itself. The supply of wheat in the market today may be 
only 10,000,000 bushels, though the stock is 1,000,000,000 
bushels; but, in the course of the season, most of the 1,000,- 
000,000 bushels is bound to be offered for sale, and, therefore, 
taking the season as a whole, the supply is certain to become 
substantially coincident with the stock.* 

Again, supply must not be confused with the amount ac- 
tually sold. The reason is analogous to that which was giv- 
en to show that we should not confuse demand with the 
amount bought. As a matter of fact, "the amount which peo- 
ple stand ready to dispose of" may be, but need not be, equal 
to "the amount which is actually sold." But, even if the two 
were always quantitatively equal, the meaning, the connota- 
tion of the two phrases would be different. "The amount 
which sellers stand ready to dispose of" plays a very great 
part in determining price ; but "the amount actually sold" is 
itself determined after price is determined. 

A second point in our definition which needs emphasis is 
suggested in the phrase "at some specific price." No state- 
ment affirming the existence of a given volume of supply can 
be recognized as adequate unless it represents supply as con- 
ditional on some particular price. Thus, it is proper to say, 

* The distinction between stock and supply is more particularly 
applicable in the discussions of the present chapter. When we come to 
consider normal price, the price which tends to prevail over some con- 
siderable period, we usually have to regard supply as conterminous 
with stock. 



230 PRINCIPLES OF ECONOMICS 

"The supply of silver is 120,000 ounces at 55 cents an ounce ;" 
but unless the current market price is implied and understood, 
it is not proper to say, "The supply of silver is 120,000 ounc- 
es." For the latter statement, literally interpreted, means that 
sellers stand ready to dispose of 120,000 ounces whether the 
price be low or high; and, obviously, such a statement would 
in most cases be very absurd indeed. 

2. The Relation of Supply to Price 

We have just seen that supply like demand is always rela- 
tive to a specific price. We must now explain this relation 
more precisely. First, the facts of supply, like those of de- 
mand, require for their complete presentation a supply sched- 
ule, a series of statements giving the amount of supply at 
each of a series of prices. This follows from the fact already 
brought out that the volume of supply is always relative to 
price. In the second place, though supply is like demand in 
the sense that its volume is relative to price, the supply chang- 
es which follow changes in price are exactly opposite to the 
demand changes. The volume of supply increases as price 
rises, and diminishes as price falls, whereas the volume of 
demand, as we have seen, diminishes as price rises and in- 
creases as price falls. In short, supply varies directly, though 
not proportionally, as price. Accordingly, a supply schedule 
for silver analogous to the demand schedule given on page 
220 would read as follows : 

The supply would be 200,000 oz. if, and only if, price were as high as 58c. 

Thesupply would be 160,000 oz. if, and only if, price were as high as S7c. 

The supply would be 130,000 oz. if, and only if, price were as high as 56c. 

The supply would be 120,000 oz. if, and only if, price were as high as 55c. 

The supply would be 1 10,000 oz. if, and only if, price were as high as 54c. 

The supply would be 80,000 oz. if, and only if, price were as high as 53c. 
The supply would be 40,000 oz. if price were as high as 52c. 



PRICE: PRELIMINARY 



231 



TABLE 3 



As in the case of demand, we shall substitute for this 
schedule one better adapted to the 
work of explanation, that is, one in 
which the changes in volume conse- 
quent on changes in price are uniform. 
Such a supply schedule for silver is 
represented in Table 3 and, diagram- 
matically, in Figure 9. 

The expression "supply has 
changed" shows the same fault of 
ambiguity that we found in "demand 
has changed." It can mean either (i) 
that supply at a particular price is 
different from what it was at the same 
price or (2) that actual supply, price 
being ignored, is different from what it was. This sec- 
ond meaning is made necessary by the fact brought out in 
our previous discussion that supply is relative to price, — will 



Price 


Supply 


cents 


000 oz. 


60 


T70 


59 


160 


58 


150 


57 


140 


56 


130 


55 


120 


54 


IIO 


53 


100 


52 


90 


51 


80 


50 


70 



40 



80 



IZO 



160 



J L 



60-\ 



55- 



50- 



^^9 



232 PRINCIPLES OP ECONOMICS 

change as price changes. The former idea would be more 
precisely stated by saying that the supply schedule has changed. 
We should, therefore, watch carefully for the double meaning 
and avoid the confusion likely to result therefrom. 

The points thus far explained concerning the relation of 
supply to price, may be put into formal shape as follows : 

Principle: The Law of the Direct Elasticity of Supply. 

Supply is always relative to a particular price expressed or 
implied and, broadly speaking, varies directly, though not 
proportionally, as price* 

3. The Interpretation of Supply Schedules 

The first point to be noted in the interpretation of supply 
schedules exactly corresponds to the first one noted under de- 
mand schedules. The supply at any particular price is a 
composite, made up of many different portions, each one of 
which, save the last, would appear at some other price, in this 
case, a lower one. Thus, the supply at 60c, 170,000 
ounces, consists of the 10,000 which comes on the 
market when, and because, price advances from 59c to 
60C, added to the 160,000 already offered when the price was 
only 59c; this 160,000, in turn, consists of the 10,000 which 
comes in when, and because, price rises from 58c to 59c, add- 
ed to the 150,000 already offered at 58c; this 150,000, again, 



* Remember that we are now dealing with the itnmediate supply 
schedule, the supply schedule which is eflfective at any one moment. 
Later we shall have to do with long-time or normal schedules, cov- 
ering a whole period of some length. To these latter schedules, the 
principle just laid down is not always applicable. In one set of cases, 
the supply may be equivalent to the whole stock and, therefore, does 
not vary at all. In another set, the supply is a potential output, which 
may be indefinitely large, provided cost of production is covered ; and, 
hence, the schedule shows no supply at prices below the one cover- 
ing cost and an indefinitely large supply at that cost price and others 
above it. But these points will be more fully presented later. 



PRICE: PRELIMINARY 



233 



is the 10,000 coming in at 58c added to the 140,000 already- 
offered at 57c ; and so on. The facts are illustrated in Figure 
10, where the little squares marked with small letters show the 
increment which supply receives in each instance as price rises 
to the level indicated. Thus, in the case of the 6oc rectangle, 
the last increment, q, appeared first when the 60c price itself 
was reached ; p came up from 59c ; o from 58c ; n from 57c ; 
m from 56c; and so on. 

With supply, as with demand schedules, a second very im- 
portant task is to distinguish the different divisions into which 



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Fig. 10 



the different sections or increments group themselves just as 
soon as any particular price is established. The principal group- 
ing, as before, is into included and exchided portions. If price 
is 55c, all possible increments of supply which are conditioned 
on a price of 55c or anything lower, will be included incre- 
ments ; while all possible increments of supply which are con- 
ditioned on a price of 56c or anything higher, will be exclud- 
ed increments. Again, among the included increments, the 
most important is the marginal one, the one which is the last 
to come in when a particular price is being estabHshed. The 
remainder of these included increments we will call the intra- 
marginal increments. The excluded increments will also be 



234 



PRINCIPLES OF ECONOMICS 



called the extra-marginal ones. The location of these various 
sections of supply is plainly indicated in Figure ii. 

Another point which, although fairly obvious, needs the 
emphasis of further comment, is the following: In our ex- 
ample, the increment of supply which comes in at 55c is the 
last one to come in and, being the last, it is by definition the 
marginal increment of supply. But 55c is the highest of the 
prices at which any supply comes in. Hence the marginal in- 
crement of supply is the increment coming in with that price, 
among all the prices under which any increments come in, 

P 40 6,0 120 160 ^00 240. 

I i__j ' 1 ■ I I I I I — I — I — I — I — I — I — I — I — I . I . ii I I 111 I taA 



60- 



55 





\ 












/ 


'^"^ 






/ 


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1 


/ 


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M 


Im 


C/ 


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/ V' 


■'/AX 


/ 


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MA/'/ 


^^n eluded 



Exeludlfdl 



m; 



Fig. II 

which is the highest. This is just the opposite of what we 
found to be true in the case of demand ; for the marginal in- 
crement of demand is the one which comes in at the lowest 
of all those prices which bring in any additions to demand. 
(Compare Figures 7 and 11.) The same contrast between 
supply and demand schedules shows in the intra-marginal and 
extra-marginal increments. The intra-marginal increments 
of supply come in at prices below the marginal one, while the 
intra-marginal increments of demand come in at prices above 
the marginal one. On the other hand, the extra-marginal in- 
crements of supply come in at prices above the marginal one, 
while the extra-marginal increments of demand come in at 
prices below the marginal one. 



PRICE: PRELIMINARY 235 

Two other concepts closely related to those just expound- 
ed are the marginal supply price and the first extra-marginal 
supply price. These phrases designate in each case the price 
which must be realized in order to bring out the correspond- 
ing increment of supply. Their mean- 
ing can best be shown by supposing 
for the moment that supply does not 
change with every change in price but 
remains constant under several prices, 
as represented in the accompany- 
ing table and Figure 12. After the 
51c price has been passed, supply re- 
ceives no increment until 57c is 
reached. In consequence, 51c is the 
marginal supply price so long as actual 
price is anything from 51c to 56c; 
while the first extra-marginal supply 
price is 57c. In these marginal and 
extra-marginal prices, we have the same antithesis between sup- 
ply and demand schedules as has appeared in other connections. 
The marginal supply price is the highest of all the prices on 
which depends the coming in of the included increments of sup- 
ply ; while, as we saw, the marginal demand price is the lowest 
of the prices on which depends the coming in of the included in- 
crements of demand. So the first extra-marginal supply price 
is the one next above the highest of all included supply prices, 
while the first extra-marginal demand price is the one next he- 
low the lowest of all included demand prices. 

The supply schedule embodied in Figure 12 was purposely 
so constructed as to make it possible for the marginal supply 
price to differ from the actual price. But the typical supply 
schedule for any moment is more commonly like the one given 
in Figure 1 1 ; and, under that schedule, the marginal supply 
price and the actual price would necessarily coincide. Never- 
theless, the concept of marginal supply price is not super- 



Price 


Supply 


cents 


000 oz. 


59 


no 


58 


100 


57 


90 


56 


80 


55 


80 


54 


80 


53 


80 


52 


80 


51 


80 


50 


70 


49 


60 


48 


50 



236 



PRINCIPLES OF ECONOMICS 



fluous. As will presently appear, this coincidence of the mar- 
ginal supply price and the actual price is, in part at least, 
due to the fact that the marginal supply price determines the 
actual price, — brings the actual price into coincidence with it- 
self ; and this becomes a fact of much importance in the deeper 
determination of prices, which we study in later chapters. 



9 ^P 

I I ■ ■ ' 



80 
-I t__l ■ ■ 



6C- 



55 



5C- 



l£0 IfeO 
— 1 — I — I I L_i 



m 



m, 




E.xri-a-Marg\na'V 



Marojlnal 



Xnrra-MarginoA 



Fig. 12 

It is hardly necessary to add that we often have occasion to 
apply the terms marginal and extra-marginal to sellers. Mar- 
ginal sellers are those who offer to sell some or all of their of- 
ferings only when, and because, actual price has risen to the 
marginal supply price. In other words, marginal sellers are the 
ones responsible for the marginal increments of supply. Their 
offerings would not be made, if price were lowered. Extra-mar- 
ginal sellers are those responsible for the extra-marginal incre- 
ments of supply. They, of course, make no sales and are com- 
monly referred to as excluded sellers. 



IlI/U STRATI vE ProbIvE;ms 

I. Suppose the conditions of supply of Milton's autographs 
to be such that 15 would be offered if the price were $200; 13, 
if it were $175 ; 12, if $150; 9, if $140; 8, if $125 ; 5, if $110; 4, 
if $100; 2, if $90; and i, if $75. 



PRICE: PRELIMINARY 237 

(a) Make out this supply schedule in tabular form. 

(b) Make out a combined demand and supply schedule us- 
ing a demand schedule of your own. 

2. Suppose the supply schedule for cordwood on a certain 
Saturday to be as follows : i cord offered if price is $4.50 ; 2, if 
price is $4.75 ; two more, if $5 ; three more, if $5.25 ; 10 in all, if 
$5 :5o; 17, if $5.75 ; and 8 more, if $6. 

Make out a combined demand and supply schedule for this 
wood using a demand schedule of your own. 

3. Suppose that the supply schedule for silver at a certain 
date is represented by the accompanying table, and answer the 
questions which follow : 

(a) Interpret the last five lines, 
beginning at the last ; also the tenth to 
the fifth. 

(b) What would be the margin- 
al increment of supply if actual price 
were 55c? 60c? 63c? 58c? 52c? 65c? 

(c) What would be the first ex- 
tra-marginal increment of supply if 
actual price were 54c ? 56c ? 59c ? 64c ? 
67c? 

(d) What would be the marginal 
supply price if actual price were 67c? 
65c? 63c? 62c? 59c? 55c? 

(e) What would be the first ex- 
tra-marginal supply price if actual 
price were 66c? 63c? 6ic? 59c? 55c? 
52c? 

(f) Who would be the marginal 
sellers if actual price were 67c? 64c? 
63c? 59c? 56c? 54c? 

(g) Who would be the first ex- 
tra-marginal sellers if actual price 
were 66c? 6ic? 59c? 58c? 55c? 52c? 



Price 


Supply 


cents 


000 OS. 


68 


163 


67 


150 


66 


150 


65 


142 


64 


135 


63 


120 


62 


120 


61 


120 


60 


112 


59 


ICX) 


58 


100 


57 


94 


56 


85 


55 


85 


54 


85 


53 


72 


52 


72 


51 


60 



CHAPTER XV 

PRINCIPLES GOVERNING THE IMMEDIATE 
DETERMINATION OF PRICES 

In order to make an adequate study of price, it seems al- 
most indispensable to attack that problem at successive levels, 
in other words, with successive degrees of thoroughness. We 
shall begin, therefore, by trying to settle the more superficial, 
phases of the problem; follow this with a solution somewhat 
more thorough; and finish with an attempt to penetrate the 
whole matter to the bottom. Our study will thus break rough- 
ly into three parts: (i) the immediate processes of price de- 
termination, — market price, (2) the intermediate processes, — 
normal price, and (3) the ultimate processes. All such divi- 
sions are of course more or less arbitrary, but the one used 
will, I believe, justify itself as we proceed. The present chap- 
ter, then, is concerned with the immediate processes of price 
determination. 

Section A. The Law of Single Price 

From the facts of demand and supply presented in the last 
chapter, the student might naturally expect to find each com- 
modity selling for several different prices. The appearance of 
a particular portion of demand, we learned, is conditioned on 
the establishment of one particular price, the appearance of 
another portion on the establishment of another price, and so 
on; and an exactly similar statement is true for supply. At 
almost any price, then, buyers could find someone ready to 
sell, and sellers could find someone ready to buy. Even if the 
forces we are about to study seemed likely to set up a certain 
price, say 55 cents in our silver problem, why is it not reason- 



IMMEDIATE PRICE DETERMINATION 239 

able to expect that sales would after all be made at both higher 
and lower prices? 

Under some circumstances, this would undoubtedly prove 
to be the case. If several buyers with different notions as to 
what they wish to pay, go to as many different sellers, and, 
without inquiring of more than one seller make their pur- 
chases, some will certainly pay more and some less for the 
same commodity. The reason is that each buyer is unaware 
of the offerings of sellers other than the one he has visited. 
Similarly, if various sellers are dealing each with an isolated 
customer, some will get larger prices and some will accept 
smaller, because each is unaware of what other customers 
might be willing to pay. Even in the same trading room it 
sometimes happens that the noise, crowding, and excitement 
so operate as practically to separate the sellers and buyers into 
different groups, making sellers in one part of the room una- 
ware of what buyers in another part will pay, and buyers in 
one part unaware of what sellers in another part will take. 
Here also, therefore, some buyers will pay more than they 
would really need to if they looked about them a little, and 
some sellers will accept less. 

But the cause of these variations is plainly something ab- 
normal. The market described is not even approximately the 
perfect market which our study postulates. Full competition 
between the different sellers on the one side and the differ- 
ent buyers on the other is not realized. Some of the sellers 
do not have a chance to provide every buyer with an oppor- 
tunity to purchase from them. Some of the buyers do not 
have a chance to provide every seller with an opportunity to 
make a sale to them. If all sellers and all buyers did so pro- 
vide, the result would be very different. No buyer would pay 
more than any other, because other sellers, desiring to get his 
custom, would underbid the seller about to receive the excep- 
tionally high price, — would so to speak, force the buyer to 
take their wares at the lower price. Neither would any seller 



240 PRINCIPLES OP ECONOMICS 

accept less than any other, because buyers other than the one 
about to get the commodity at the lower price would promptly 
overbid that one, — would, so to speak, force the seller to take 
a higher price. In a market which is truly single and theoret- 
ically perfect, therefore, any commodity at any one time must 
be selling at a single price. 

In the real world, of course, there are no theoretically per- 
fect markets. The great exchanges for wheat, cotton and 
steel where many buyers and sellers actually meet in 
the same room and where almost every conceivable means is 
available for informing one's self of the facts, doubtless at 
times approach perfection ; but ignorance, folly and the fail- 
ure of competition always prevent the condition from being 
reached; and in ordinary markets, naturally, this is much 
more emphatically true. Nevertheless, the tendency toward 
a single price set up by the forces mentioned above is always 
sufficiently strong to be of real and practical significance. Even 
in the retail trade, differences between the prices of the same 
commodity in the same market or in connected markets are 
at once recognized as abnormal. The smallest differences are 
remarked upon ; anything like an indefinite enlargement is 
quite impossible; and with the spread of greater knowledge, 
alertness and skill among buyers and sellers they must tend 
rapidly to diminish and disappear. 

Summarizing the above discussion, we have the following 
principle : 

Principle. The Law of Single Price. 

Within the limits of a truly single and theoretically per- 
fect market, no commodity can have fnore than one price at 
the same time; and even within the limits of imperfect mar- 
kets or groups of connecting markets, any comm,odity must 
tend to have a single price, — allowance being made in the lat- 
ter case for the expense of shifting from one to another of 
the connecting markets. 



IMMEDIATE PRICE DETERMINATION 241 

Section B. The Law o£ Supply and Demand 

We are now prepared to explain the actual processes of 
price-determination through what is commonly known as the 
law of supply and demand. In doing this, we shall deal with 
demand and supply schedules of the regular, symmetrical sort 
which we have called typical, though it will be necessary later 
to note some variations from these. Let us begin by placing 
before ourselves, in both tabular and diagrammatic form, our 

typical demand and supply sched- 
ules combined into one. In the 
table, the common price is placed 
in the middle column, while the 
demands corresponding to the sev- 
eral prices appear in the first col- 
umn, and the supplies in the third. 
The diagram in Figure 13 repre- 
sents the supply rectangles super- 
posed on those of demand in such 
a way that the boundaries of the 
rectangles which express demand 
and supply, respectively, at any 
particular price, coincide as far as 
their length will permit. To make 
it easy to distinguish at a glance 
the demand and supply rectangles, the right hand ends of the 
latter are traced in a heavy line. 

From all the data now before us, it is easy to derive a se- 
ries of propositions containing the most important facts of 
immediate price-determination. First, any price at which 
supply is in excess of demand tends to he replaced by a lower 
price, through the competition of sellers. The reason is not 
far to seek. As long as such a price prevails, sellers can not 
expect to dispose of as much of their goods as they wish to 
sell even at a lower price. Thus, in the accompanying sched- 



Demand 


Price 


Supply 


000 OS. 


cents 


000 OS. 


70 


60 


170 


80 


59 


160 


90 


58 


150 


100 


57 


140 


no 


56 


130 


120 


55 


120 


130 


54 


no 


140 


53 


100 


150 


52 


90 


100 


51 


80 


[70 


50 


70 



242 



PRINCIPLBS OF ECONOMICS 



ule, a price of 56 cents would make supply 130,000 ounces 
and demand only 110,000, though sellers are ready to dispose 
of 120,000 ounces even if they can not get more than 55 cents. 
Under these conditions, sellers would have two reasons for 
bidding price down: (a) such a procedure would increase the 
demand by 10,000 ounces, and (b) it would decrease the 
amount offered by an equal amount. 

In the second place, any price at which demand is in ex- 
cess of supply must tend to he replaced by a higher one, 
through the competition of buyers. As long as such a price 
prevails, buyers can not expect to get as much of the goods as 

rt 4.0 8,0. 120 m 



60 



6pr 



6S-P 



i>: 




%• 13 



they wish to buy even at a higher price. Thus, a price for our 
silver of 54 cents would make demand 130,000 ounces, and 
supply only 110,000, though buyers are ready to take 110,000 
at 55 cents. The 55 cent buyers would, therefore, have two 
reasons for bidding the price up to their figure (a) by doing 
so, they would bring in 10,000 more units of supply, and (b) 
they would shut out 10,000 units of demand. 

A third point which necessarily follows from the two just 
made is that equilibrium in the price-making forces can not 
be reached at any price which makes demand and supply un- 



IMMBDIATB PRICE DETERMINATION 243 

equal; hence all such prices are necessarily shut out. Prices 
which fail to equalize demand and supply can not stand. 

On the other hand, we can readily see that any price which 
does equalize these two quantities will bring about equilib- 
rium, and can, therefore, stand. The only forces at work are 
the self-interest of sellers, on the one side, and that of buy- 
ers, on the other. But both these become quiescent when a 
price is reached at which supply and demand are equal. All 
sellers who are ready to sell at so low a figure are assured of 
disposing of their wares ; while all buyers who are ready to 
buy at so high a figure are assured of getting what they want. 
It follows that, if a price can be found which equalizes supply 
and demand, that price will secure equilibrium among the 
price-making forces. And, if it does this, if it leaves no force 
exerting an upward or a downward pull, that price must tend 
to prevail. 

We have just seen that, if a price be found at which 
demand and supply are equal, that price must tend to prevail 
as against any prices at which either supply or demand is in 
excess of the other. We have now to add that, with what 
we have called the typical demand and supply schedule, there 
is hound to he such a price. This results inevitably from the 
principles governing these schedules. Supply varies in the 
same direction as prices ; demand varies in the opposite direc- 
tion. In consequence, there is necessarily some price at which 
they are equal ;* at some point the curves representing them 
are bound to intersect. It follows, then, that, with typical 
supply and demand schedules the price which tends to be es- 
tablished must be one which equates supply and demand. 

We will now summarize the preceding discussion in a for- 
mula which contains the most essential elements of what is 
commonly called the Law of Supply and Demand. 



''' A slight qualification of this will appear in the course of our dis- 
cussion. 



244 PRINCIPLES OP ECONOMICS 

Principle. The Law of Supply and Demand 

Given a typical demand and supply schedule, price must 
tend to rise so long as demand is in excess of supply and to 
fall so long as supply is in excess of demand;"^ it must there- 
fore move up or down till it reaches a figure which equates 
supply and demand; and at this point it can rest, since here 
the price-moving forces become quiescent. 

The principle just set forth covers the main part of what 
is really essential in the law of supply and demand. Other sig- 
nificant points are little more than corollaries of this. One of 
the first concerns the effect on price of changes in either sup- 
ply or demand, — meaning, remember, changes in the sched- 
ules — the different supplies or demands at a series of prices. 
As respects supply, the answer is contained in the following 
corollary : 

Corollary i. A rise or fall in the supply schedule tends 
to bring about an opposite {not proportional) change in price, 

A glance at the facts will show this conclusion to be inevi- 
table. A rise in the supply schedule means that supply is now 
in excess at the going price. But the principle tells us that 



* On this point a doubt may arise in the student's mind if he gets; 
to experimenting with supply and demand schedules. For it is not 
difficult to change the schedule used in our discussion so that there 
is no longer any price at which supply and demand are just equal. 
Such a schedule would result, if we make demand at 60 cents 6o,ooO' 
ounces instead of 70i,ooo, increasing it as before by 10,000 each time, 
and leaving the supply column as before. In such a schedule, supply 
would be 10,000 in excess at 55 cents, while demand would be the 
same amount in excess at the next lower price, 54 cents. This diffi- 
culty, however, is only a seeming one. In a case like that supposed, 
buyers and sellers would simply reckon prices in a smaller unit. That 
is, they would make bids at 54^ or 54^ or 54^ and so reach a point 
at which supply and demand would almost certainly come to equality. 



IMMEDIATE PRICE DETERMINATION 245 

price must tend to fall so long as supply is in excess of de- 
mand. The rise in supply must therefore tend to bring about 
a fall in price, that is, an opposite change. On the other hand, 
if the supply schedule declines in volume, demand at the go- 
ing price, the price which made supply and demand equal, 
will be in excess of supply. But the principle tells us that 
price must tend to rise so long as demand is in excess of sup- 
ply. A decline in the supply schedule must, therefore, tend 
to bring about a rise in price, an opposite change. 

Corollary 2. A rise or fall in the demand schedule tends 
to bring about a like {not proportional) change in price. 

The argument is similar to that employed for the corol- 
lary above. A rise in the demand schedule makes demand at 
the going price in excess of supply ; under the principle, there- 
fore, it tends to cause a rise in price, which constitutes a like 
change. A fall in the demand schedule makes supply at the 
going price in excess of demand; and this, under the princi- 
ple tends to bring about a lower price, which is also a like 
change. 

Corollary 3. A commodity^ the schedule of which shows 
a higher ratio of demand over supply at a given price than 
the schedule of another commodity shows at the same price, 
zvill also shozv a higher actual price. 

Thus, if at a price of 51 cents, the ratio of the demand for 
silver over the supply is 2 to i, while that of copper is 2 to 
3, the price of silver will naturally be higher than that of cop- 
per. The price of silver would have to move up to equate 
supply and demand ; while that of copper would have to move 
down. This corollary emphasizes the point which the busi- 
ness world somewhat inexactly expresses in saying that "price 



246 PRINCIPLES OF ECONOMICS 

is all a matter of the ratio between supply and demand." Its 
importance lies in the explanation it provides of the great, 
and often very trying, differences in the prices of things, and 
especially in the remuneration obtainable for supplying dif- 
ferent types of services. 

Section C. The Relation of Actual Price to Certain De- 
mand and Supply Prices 

In the reasoning employed in Section B to establish the 
principle of supply and demand, we necessarily touched up- 
on some of the deeper forces and processes which are deter- 
mining prices and bringing them under the rule of supply and 
demand. We will now inspect these forces a little more close- 
ly. In particular, we will show the dependence of the prices 
actually established on certain special prices among the differ- 
ent demand and supply prices. 

The method which we employed to prove that the one price 
at which demand and supply are equal must prevail was to 
show that all other prices are certain to be shut out by the 
competition of either buyers or sellers. Actual price, we saw, 
must not go above 55 cents lest it should shut out the marginal 
buyers, nor up to 56 cents lest it should let in new sellers ; and 
on the other hand, it must not go below 55 cents lest it shut 
out the marginal sellers nor down to 54 cents lest it let in new 
buyers. Now, if these same facts be interpreted from our 
present standpoint, they tell us that the upper limits of price 
are fixed, or may be fixed, by either of two prices of the sched- 
ule, and that the lower limits are, or may be, fixed by either 
one of another two prices of the schedule. Let us now define 
more precisely these limiting prices. 

Price could not go above 55 cents lest it should shut out 
the marginal buyers. But 55 cents, as the price which brought 
in the marginal buyers, is the marginal demand price. It fol- 
lows that one of the upper limits of price is the marginal de- 
m.and price. Again, price could not go up to 55 cents be- 



■ IMMEDIATB PRICE DBTERMINATION 247 

cause this would let in new sellers. But the price which will 
let in new sellers we have already defined as the first extra- 
marginal supply price. Consequently, the second possible up- 
per limit of price is the first extra-marginal supply price. 

Turning now to the lower limit, price could not go below 
55 cents lest it shut out the marginal sellers. But 55 cents, as 
the price which brought in the marginal sellers, is the mar- 
ginal supply price. Accordingly, one of the possible lower 
limits of price is the marginal supply price. Finally, price 
could not go down to 54 cents because that figure would let in 
new buyers. But the price which would let in new buyers we 
have already designated the first extra-marginal demand price. 
Hence the second possible lower limit of actual price is the 
first extra-marginal demand price. We have thus four prices 
which act or may act as the limits within which actual price 
must be established. 

In reading the above account of this matter, the student 
may object that, since both the limiting prices, above or be- 
low, fix the same price, it is hardly worth while distinguishing 
more than one of them. If actual price can not go below 55 
cents, it certainly can not go down to 54 cents ; if actual price 
can not go above 55 cents, it of course can not go up to 56 
cents. This is no doubt quite true as applied to these per- 
fectly symmetrical schedules which were used to explain the 
working of the law of supply and demand. We shall find, 
however, that many schedules, anyhow many supply sched- 
ules, are much less regular than those used. In such cases,- 
only two or, sometimes, only one, of the four limiting prices 
may be actually operative. Our analysis, therefore, could be 
adequate only if it brought out all the limiting moments, as was 
done above. 

To clear up more completely the matter just commented 
upon, let us imagine a schedule in which the limits set by the 
different moments would not coincide. Thus, in the accom- 
panying table, demand remains constant at 120,000 ounces, 



Demand 


Price 


Supply 


OOO OS. 


cents 


000 oz. 


80 


61 


150 


90 


60 


140 


100 


59 


130 


no 


58 


120 


120 


57 


120 


120 


56 


120 


120 


55 


120 


130 


54 


120 


140 


53 


120 


150 


52 


no 


160 


51 


100 


170 


50 


90 



248 PRINCIPLES OF BCONOMICS 

from 57 cents to 55 inclusive, 
while supply remains constant at 
120,000 ounces from 58 cents to 
53 inclusive. Since supply and de- 
mand are equal only at three prices, 
57, 56, and 55 cents, the actual 
price must be one of these. But 
with actual price one of these, the 
marginal demand price must be 57 
cents, since this is the one which 
brought in the last increment of 
demand ; the first extra-marginal 
supply price must be 59 cents, 
since this would bring in the next 
increment of supply ; the marginal 
supply price must be 53 cents, since 
this brought in the last increment 
of supply ; and the first extra-marginal demand price must be 
54 cents, since this would bring in the next increment of de- 
mand. 

But actual price, as already noted, can not go above 57 
cents, the marginal demand price, though as far as the first 
extra-marginal supply price is concerned, it could go to 58 
cents. The latter price, therefore, plays no part in the final 
fixing of the actual price. Again, actual price can not go 
down to 54 cents, the first extra-marginal demand price, 
though, for all that the marginal supply price affects the mat- 
ter, it could go down to 53 cents, — supply does not begin to 
fall ofif till 52 cents has been reached. Plainly, then, in a case 
of this sort, two of the limiting moments of price, those which 
come from supply, are inoperative, — both the upper and low- 
er limits of price being fixed by demand prices. Further, it 
is plain that both of the moments coming from the demand 
side have to be taken into account; for neither actually fixes 
price, each of them only fi.ves one of the limits within which 
price may range. 



IM MUD I ATE PRICE DETERMINATION 249 

In the schedule just used to show that it is not necessary 
that all the four limiting prices should be operative in every 
case, supply remained constant for a longer series of prices 
than demand, and so was prevented from taking part in actual 
price-determination. It is manifest that if the hypothesis 
were reversed, the result would also be reversed: the limits 
of price variation would now be fixed by the marginal sup- 
ply price and the first extra-marginal supply price. Sellers 
would not permit actual price to go up to a certain point lest 
they should let in a new supply, while buyers would not let 
actual price go below a certain point lest they should shut out 
a portion of the supply. 

It is hardly necessary to add that the two types of sched- 
ules just used do not exhaust the possibilities of the matter. 
Another could be imagined under the working of which the 
upper limit of price was set by the marginal demand price, 
while the lower was set by the marginal supply price. Under 
still another type, the upper limit would be set by the first ex- 
tra-marginal supply price, and the lower by the first extra- 
marginal demand price. Finally, there is one type of sched- 
ule, and this will prove to be a very important one, under 
which the immediate fixing of price must he credited to just 
one of our four limiting prices, namely, the marginal supply 
price. 

The purpose of the preceding discussion was to empha- 
size the immediate dependence of actual price on one or more 
of just four demand and supply prices. To avoid possible 
misunderstanding, it is perhaps best to insert a caution at this 
point. In giving so decisive a place to certain special demand 
and supply prices, we do not mean that other demand and 
supply prices have no part in the matter. To establish any 
price whatever, demand and supply must come to an equality. 
With the schedule which appears on page 241, this equality 
of demand and supply was reached with each at 120,000 
ounces, and at an actual price of 57, 56, or 55 cents. But 



250 PRINCIPLES OF ECONOMICS 

with neither demand nor supply was this total brought out 
by the last or marginal price acting alone. Thus, the mar- 
ginal demand price, 57 cents, contributed to this total only 10,- 
000 ounces, 110,000 ounces coming down from previous, high- 
er prices. If these earlier increments of demand had not 
come in, — if only the total demand had been limited to the 
10,000 ounces which appear at 57 cents, — equality of demand 
and supply could have been reached only at a much lower 
point, and, so, actual price would have been much lower. The 
whole demand of 120,000 ounces was necessary to make pos- 
sible an actual price as high as 57 cents. It follows that the 
intra-marginal demand prices, the prices which were able to 
bring out the earlier increments of demand, have a part in the 
fixing of the actual price as truly as do the marginal and the 
first extra-marginal demand prices. 

But now we must be careful lest, in trying to avoid one 
misunderstanding, we fall into another equally objectionable. 
Although we admit that demand and supply prices other than 
the marginal and first extra-marginal ones share in the 
fixing of actual price, we by no means rehnquish the con- 
tention that the limits of actual price are immediately 
determined by one or more of the four prices named. 
While total demand is obviously made up of the sum of all 
the increments of demand, these different increments must not 
be thought of as perfectly homogeneous units entering into 
the total in just the same way. The case is not analogous to 
that of a pair of scales, the measuring pan of which is loaded 
with several different weights to balance the object being 
weighed. In bringing down the pan, each of those weights 
acts in just the same way as every other. The case is quite 
otherwise with the different increments of demand or supply. 
While all influence the result, they function quite differently 
in doing this. The explanation is that each is in a very im- 
portant sense different from every other. This difference ' con- 
sists in the fact that the emergence of any one depends on the 



IM MEDIA TB PRICE DE TERM IN A TION 25 1 



INSERT, p. 251 



ILLUSTRATIVE Problems. 

1. "On the Black Friday of 1869, gold was sold on one side of the 
room for $1.60 when it was being sold on the other for $1.35, etc." — 
Sumner. 

(a) Why is such a fact noteworthy from the economic point of view? 

(b) How was it to be explained, do you suppose? 

2. Professional men, especially those of the medical profession, fre- 
quently try to eliminate the law of single price in respect to their services. 

(a) Why is it for the interest of physicians to get rid of this law? 

(b) Give some reasons why they are quite likely to have more or less 
success in carrying out this policy. 

3. "The price can not long remain above cost of production. For, so 
long as it is above, profits will be exceptionally high; this fact will cause 
production to increase ; as a result supply will become . . . . , and 
price will . . . ." 

Fill in the blanks, using the Law of Supply and Demand. 

4. "The demand for wheat was increased beyond the capacity of the 
best lands to furnish it, and so a new supply was brought out by putting 
inferior lands under cultivation." 

To make that reasoning quite complete, one or two other links should 
have been put in between the premise and the conclusion. Supply those 
links. 

5. "Demand having increased, price rises. But this higher price cuts 
down demand; and so price comes right back to where it was in the first 
place." 

Show that this result could not be reached in a normal case. 

6. The high rate of exchange made exporting more than usually 

profitable. As a result, the supply of cotton for the foreign market 

tKe price . . . . , this caused the foreign demand to . . . . , 
and so exports .... Fill out the blanks, applying the Law of 
Supply and Demand. 

7. Change the demand and supply schedule on page 248 so that the 
limits of price-variation would be fixed by the marginal supply price and 
the first extra-marginal supply price. 

8. Change. the above schedule so that the limits of price variation 
would be fixed by the marginal demand price and the first extra-marginal 
demand price. 

9. "Five persons from a shipwrecked steamer are temporarily saved 
by getting on a raft; a sixth climbs on, and the raft sinks. Obviously it 
was not just the sixth person who sank the raft, but all the six persons. 
No more do the marginal and first extra-marginal demand and supply 
prices by themselves fix actual price. All the demand and supply prices 
equally share in the process." 

Show that the analogy is false. 



250 PRINCIPLES OP ECONOMICS 



d 
\ 

tl 
b 
tl 
tl 
^^ 

a 
o 

ir 

P' 

si 



IMMEDIATE PRICE DETERMINATION 251 

appearance of its own special price, or one lower, in the case 
of demand, or one higher, in the case of supply. This being 
true, the different increments can not be treated as intercon- 
vertible, — each one playing the like role with every other. The 
lowest-priced of all the demand increments and the highest- 
priced of all the supply increments hold key positions. Any 
price which will bring them out can prevail, even though it dif- 
fers ever so much in one direction from the special price nec- 
essary to bring out any other increment of the total. On the 
other hand, no price which does not bring them out can pre- 
vail, though it brings out every other increment of either de- 
mand or supply. In short, the immediate determination of 
price limits is with the four demand and supply prices which 
have been so often named ; the part of other demand and sup- 
ply prices is to assist in determining what prices shall occupy 
these key positions. 

In closing this rather long discussion, I am going to add 
one more illustration from analogy to the very considerable 
number which have been used by different writers in this con- 
nection. Suppose that the owner of a meat market located 
in a small town starts out to buy a dozen steers among the 
neighboring farmers, and that he can get two from the first 
farm on his route, one from the second, three from the third, 
one from the fourth, and so on. How far will he have to go 
to get the whole twelve? Manifestly, the answer is: as far as 
the distance to the farm at which he buys the last one or 
more necessary to make tip the full number. In other words, 
the total distance to be traversed will depend immediately on 
the distance to the marginal increment, and on that only. 
But this distance, in turn, will manifestly depend in part on 
the increments obtainable at farms nearer by. In consequence, 
these earlier increments share in determining the total dis- 
tance. Their influence, however, is only indirect. They help 
to make the total distance short or long because, and in so far 
as, they make the distance to the marginal increment short 
or long. 



CHAPTER XVI 

NORMAL DEMAND SCHEDULES 

At the beginning of the last chapter, it was explained that 
our study of price-determination was to be divided into three 
parts according as it was concerned with the immediate, the 
intermediate, or the ultimate stages of price-determination. 
The first of these stages has already been covered. In the 
present chapter, we begin our study of the second. 

The necessity for a separate treatment of these two stages 
can be made clear by means of an illustration. In the early 
nineties of the last century the bicycle, which had just re- 
cently been invented, was in process of evolution. At that 
time, the price of any machine likely to prove serviceable to 
the buyer, was in the neighborhood of $ioo to $125. That 
this price was more or less fully the result of the natural 
working of the laws of price which were considered in our 
last chapter, there can be no question; at any rate it was 
doubtless one which brought demand and supply into ap- 
proximate equality. However, the price was believed by all 
well-informed persons to be something quite temporary in 
character. Prospective buyers with lean pocket-books or with 
more than the usual amount of prudence and patience confi- 
dently expected and waited for a decided fall. "The present 
price," said they, "is plainly abnormal. Doubtless for the 
time being various causes may enable producers to hold the 
price up to $100; but this cannot last many years." 

Here we find implied the chief reason for distinguish- 
ing between the study of the immediate processes of price- 
determination which occupied the last two chapters and the 
study of deeper processes which begins in this. Behind the 
price temporarily prevailing under the influence of immediate 
forces, there is a price which tends to be established by the 



NORMAL DEMAND SCHEDULES 253 

more permanent forces and toward which the actual price is 
constantly being driven. And this other price, which we call 
the "normal," is in the long run of far greater significance 
than the one established by immediate forces. Three chap- 
ters will therefore be given to the study of normal price ; 
this chapter and the next to preliminary matters, and the last 
to the actual processes of normal price-determination. 

While the meaning of the phrase "normal price" is in- 
dicated in the last paragraph, an additional comment or two 
may serve to make it clearer. It means a price which is al- 
ways tending to prevail during a given period as a result of 
the action of those forces which operate throughout the pe- 
riod, especially the larger of those forces. But, though al- 
ways tending to prevail, we should note that, because of the 
interference of temporary forces, normal price seldom if ever 
does prevail ; and for this reason it is often defined as the 
price toward which actual price constantly gravitates, or about 
which actual price constantly oscillates. Again, normal price 
should not be confused with average price, which is a mere 
arithmetic concept. The two might coincide quantitatively, 
though it is probable that they seldom do. In any case, they 
differ radically in meaning or connotation; and, if a certain 
price were at once the average of all actual prices for a given 
period and the price tending to be established by the per- 
manent forces of that period, we should be interested in that 
price solely because it fulfilled the second condition. 

One of the first matters to be emphasized in connection 
with normal price is that the law of supply and demand al- 
ready presented still governs the immediate determination of 
price. In creating a tendency for some particular price to 
prevail, the permanent forces necessarily operate through, and 
only through, their power to determine the immediate demand 
or supply schedule. Thus, if certain forces tend to estab- 
lish a normal price of 30 cents for wooden chairs, they do 
this simply because they have the power so to influence the 
supply schedule that, every time the price goes above or be- 



254 P RING IP LBS OP ECONOMICS 

low 30 cents, a tendency is established to pull it back to that 
point under the natural working of the Law of Supply and 
Demand. 

But the law of supply and demand dominates normal 
price in an even deeper sense. Besides the immediate de- 
mand and supply schedules which at any moment prevail 
there are long-time or normal demand schedules and long- 
time or normal supply schedules covering the whole period 
under consideration. Thus, when the immediate demand 
schedule for silver on a particular day in 19 18 was 20,00Q 
ounces, if price were 60 cents; 22,000, if 59; 25,000, if 58; — 
there must also have been a schedule for the whole year 1918, 
a schedule which might have read something like this : 260, 
000,000 ounces wanted if price were 60 cents; 275,000,000, if 
it were 59 ; 290,000,000, if 58. Similarly, alongside the imme- 
diate supply schedule there must also have been a long-time 
supply schedule on a much larger scale. 

Now the price which is tending to be established all through 
this period, — the normal price, — is determined by the rela- 
tion between these long-time or normal demand and supply 
schedules. Thus, suppose that the schedules for silver given 
on page 241 represent the long-time supply and demand con- 
ditions for that metal, rather than the immediate ones. Thert 
the price which these schedules would naturally estabUsh, 55 
cents, would tend to be the normal price for the whole period,, 
one year; just as, in the example given, it tended to be the 
market price for the single day when those schedules were 
effective. With these long-time schedules, as with the market 
schedules, there would be one and only one price at which de- 
mand and supply were equal; and, under the normal working 
of economic forces, this one price would tend to be estab- 
lished. In undertaking our deeper study of price, therefore,, 
we are not leaving behind the law of supply and demand, but 
merely bringing out forces and processes which lie a little 
deeper. In fact, all our later exposition of the theory of 



NORMAL DEMAND SCHEDULES 



255 



price will, in a sense, do little more than elaborate and com- 
plete the principles of supply and demand. 

We have seen that the deeper forces determining normal 
price necessarily act through supply and demand, — long-time 
supply and long-time demand ; so that behind normal price 
we find normal supply and demand schedules, just as behind 
market price we find market supply and demand schedules. 
The remainder of this chapter will be devoted to normal 
demand schedules. 

In analyzing normal demand schedules, our first need is 
to consider the deeper factor or element which lies behind de- 
mand prices. What determines the prices which in the long 
run buyers stand ready to pay for a given quantity of goods? 
In answering this question, it is necessary that we should go 
to the schedule of the individual buyer and ask ourselves what 
motive or motives finally determine his conduct. For, obvious- 
ly, the general or social schedules with which we have to 
deal are composites or aggregates of numerous individual 
schedules. Thus, when we say that, according to the general 
demand schedule for silver, 180,000,000 ounces are wanted if 
price is 55c, we mean that the different amounts of demand 
at 55c from the schedules of all the different buyers of sil- 
ver will, when added together, give a sum of 180,000,000 
ounces. 

The student should not, of course, be misled by this em- 
phasis upon the priority of individual schedules over the gen- 
eral market schedule, into thinking those individual demand 
schedules are made tip independently of social forces. The 
wants of any individual, and, therefore, the valuations which 
he puts upon goods, are necessarily in a very great measure 
the creation of the community in which he hves, just because 
his standards, ideals, and tastes are in great measure the cre- 
ation of that community. We are born into the family, into 
society, into the state; and our ideals are never formed inde- 
pendently of these groups. But this admission does not at all 



256 PRINCIPLES OP ECONOMICS 

conflict with our doctrine that the demand schedules of the 
market are composites, made up by adding together the de- 
mand schedules of individuals. For, however large may be 
the share of social forces in the determination of our wants, 
those forces finally express themselves through the demand 
of individual men. Goods are purchased not by the group 
will, nor by the group ideal, but by concrete and separate 
persons. We proceed, therefore, to consider the normal de- 
mand schedules of the individual. Here our chief task is to 
study the elements or factors lying behind individual demand 
prices. 

First, each price appearing in the demand schedule of the 
individual is his valuation, his money estimate, of the impor- 
tance or significance to himself of the particular increment 
of his demand which is conditioned on that particular price. 
Thus, if his schedule of apples reads as follows: one peck 
wanted, at $2.00, two at $1.50 each, 3 at $1.25 each, and so 
on down to 12 at $.50 each, this means that the significance to 
him of a second peck as estimated by himself is $1.50, of a 
third is $1.25, and of a twelfth is $.50. In other words, mar- 
ginal demand prices are expressions of marginal significances 
as estimated hy the buyer. It follows that whatever state- 
ments with respect to the former, demand prices, may prop- 
erly be made, similar statements may properly be made with 
respect to significances or importances. 

It must of course be admitted that the estimates, above 
alluded to, of the significance of commodities to the individual, 
lack the precision which would be required in most other 
measurements of a scientific character. Nevertheless, these 
estimates are very real and sufficiently precise for the pur- 
poses of economic life, as is abundantly proved by the fact 
that our buyer actually decides in favor of the apples rather 
than using his money to buy something else, if in view of all 
the circumstances the price seems reasonable. 

The foregoing illustration had to do with a consumption 
product. But the same proposition could be affirmed of goods 



NORMAL DEMAND SCHEDULES 257 

bought by a manufacturer not for consumption, but to be 
used in a way to earn a profit. The prices which such manu- 
facturer stands ready to pay for given quantities of any com- 
modity express his estimates of the significance or importance 
which those quantities of the commodity have for him. Hence, 
we may treat the demand schedule of an individual for any 
commodity as, in effect, the significance schedule of that same 
commodity. Whatever we have a right to say about the de- 
mand prices of the individual's schedule, we also have a right 
to say about the significances which, in his opinion, the differ- 
ent quantities of the commodity possess for him. 

But this explanation does not go deep enough. Why do 
goods have significance to the individual, and what deter- 
mines the degree of their significance? The immediate, and 
from the economist's standpoint, the ultimate ground of sig- 
nificance or importance to an individual is utility — capacity 
in an object or condition to satisfy wants. This should be 
plain enough in the significance schedule of an ultimate con- 
sumer, for example, our householder. It is not so obviously 
true for buyers who intend to sell again the goods they have 
bought, or to use them in producing something else which 
they will sell; for the ultimate utilities of such goods or their 
products do not interest the persons dealing in them. At bot- 
tom, however, the cases are not materially different. The sig- 
nificance schedules of middle-men and producers are — and 
must be, if these persons are to make any kind of a success 
of their business — fairly faithful embodiments of the sched- 
ules of consumers. Broadly speaking, then, the thing which 
in the last analysis determines significance schedules is utili- 
ty to consumers. Further, just as the demand schedule of 
an individual for a certain commodity is based upon, and cor- 
responds to, his significance schedule for that same commodi- 
ty ; so the individual's significance schedule is based upon and 
corresponds to, his utility schedule for that same commodity. 
Hence, whatever we can say about the significances of a com- 
modity we can also say about the corresponding utilities as 



258 PRINCIPLES OF ECONOMICS 

these are estimated by the individual interested. From the 
consumer's standpoint the terms "significance" and "utihty" 
are capable of reciprocal substitution. This is not to say that 
they are synonymous, but only that, wherever we can use 
either of them in treating price-determination, we can also 
properly use the other. 

Our analysis has brought us to utility as lying behind and 
determining significances as these lie behind and determine 
the demand prices of the consumer. It will naturally be in- 
ferred from this that, in the study of individual demand 
prices, utility constitutes something final and fundamental. 
We are called upon, therefore, to give a little special con- 
sideration to the theory of utility, its meaning, and the princi- 
ples governing it. 

The general meaning of utility is already familiar to us. 
It is the capacity to satisfy wants. In view of this definition 
it might perhaps be expected that we should at once set about 
making a systematic study (i) of the different wants of 
man and (2) the properties of things whereby they are fit- 
ted to satisfy those wants. As a matter of fact, we deal 
very little in these questions. The second of the two is main- 
ly the business of the technical arts. We have considered 
its strictly economic aspects and its more important technical 
ones in discussing various phases of production, and that is 
all, as economists, we need to do. The first part of the task 
indicated — the study of wants — also receives relatively little 
attention from the economist. This study, including the na- 
ture of wants, their origin and classification, the possible and 
desirable methods of modifying them — these seem naturally 
to belong to the sciences of psychology, education, and sociolo- 
gy. In general the economist assumes that such knowledge 
of wants as is essential to his work is possessed by most in- 
telligent persons, and his special study of them is very Hmited 
in scope. To him they are simply forces, capable of a rough, 
quantitative measurement, powerful to accomplish economic 



NORMAL DEMAND SCHEDULES 259 

consequences. On this side, they demand a brief discussion, 
though Httle need be said that is not famiHar to most persons 
and promptly accepted when once presented. 

Now, the principal point which needs to be made concern- 
ing quantitative behavior of these fundamental forces, human 
wants, connects itself with the famihar fact that these wants 
are capable of satiation and that by a progressive course. Let 
us, for example, suppose ourselves to make an experiment in 
the consumption of some divisible commodity, such as food, 
starting with the smallest amount feasible for use, increasing 
it by very small increments, and noting the results. We should 
doubtless find our experience breaking into something like the 
following stages: (i) the gratification from each additional 
unit greater than from the last preceding, (2) the gratification 
from the additional unit the same as that from the preceding, 
(3) the gratification from the additional unit less than from 
the preceding, and (4) no gratification or even discomfort. 
Of these four stages, the last, plainly, falls out of reckoning; 
since no one would intentionally carry the consumption of 
any commodity into this stage. The second, again, is probably 
in most cases rather brief. Of the two remaining, the third 
is seemingly of most importance. With most of us there will 
be only a few very expensive luxuries which we get in such 
small amounts that the gratification from an additional unit 
would be greater than that derived from preceding units. In 
short, our wants, our capacity to be gratified by the great ma- 
jority of goods which we purchase or consume, will nearly al- 
ways be such that additional units will give us gratifications, 
but gratifications smaller than those derived from units just 
preceding. 

The above discussion shows that our capacity for being 
gratified by additional units of a commodity, varies inversely 
as the amount of the commodity possessed or consumed. But 
this is only another way of saying that the additional units of 
the commodity vary in their capacity to satisfy our wants, 



26o PRINCIPLES OP ECONOMICS 

their utility, inversely as the amount possessed or consumed. 
In effect, then, a unit of a commodity has no utiHty for us 
unless our wants demand its use; it has utility just in the de- 
gree that our wants demand its use ; and, most important of 
all, taking almost any commodity which we are likely to pur- 
chase or consume, the utility of new units successively added 
to our stock will constantly decline, because the wants tO' 
which they are applied approach satiation. 

Again, in view of the use already made of the term "mar- 
ginal," it is plain that the last unit added to our stock of any 
commodity, the one gratifying the least important want, would 
naturally be designated the marginal unit and the utility of 
this last unit would naturally be designated the marginal 
utility of the commodity. Using these names, then, in stat- 
ing the facts already brought out, we may formulate the fol- 
lowing principle : 

Principle. The Law of Diminishing Marginal Utility 

Broadly speaking, the marginal utility of any commodity 
will vary inversely as the quantity of that commodity in pos- 
session. 

Let us now turn back on our course, and, with this law of 
diminishing marginal utility in mind, give a fuller meaning to 
the remarks already made with reference to normal demand 
schedules. The proposition which started us on our discus- 
sion of utility told us that the significance or importance of 
anything is determined by, varies with, its utility. It follows 
that, if, taking a divisible commodity like the food of our ex- 
periment, we give to the significance of the unit last added the 
name "marginal significance" (as we gave to the utility of 
the unit last added the name "marginal utiHty"), we may 
formulate a law of marginal significance exactly analogous 
to the law of marginal utility set forth above. 



NORMAL DEMAND SCHBDULBS 261 

Principle. The Law of Diminishing Marginal 
Significance 

Broadly speaking, the marginal significance of any com- 
modity varies inversely as the quantity of that commodity in 
possession. 

Finally, it was remarked at the outset of this discussion 
that the several demand prices are expressions of the mar- 
ginal significance to buyers, of the quantity of the commodity 
demanded at the prices named. It follows that whatever we 
have said about marginal utility and marginal significance 
may also be said of marginal demand prices. 

The marginal demand price must decline as the quantity 
bought increases. 

This proposition is obviously nothing more than the con- 
verse of tKe principle of Inverse Elasticity for demand sched- 
ules which was brought out in chapter XIV. Further, this 
principle of diminishing marginal demand price explains why 
there is a principle of inverse elasticity. The quantity bought 
must decline as price rises ; for, since the marginal demand 
price varies inversely as the quantity bought, only a smaller 
quantity can have the higher marginal demand price assumed. 
In like manner, the quantity demanded must increase with a 
lower price, for only a larger quantity can have a demand 
price as low as the new one assumed. 

One more point, though obvious enough, will have such 
usefulness to us in a later chapter that it calls for special 
mention. We have seen that demand prices are what they 
are because significance and utility are what they are ; and 
hence, whatever may be affirmed of demand prices may also 
be affirmed of significance or utility. Now the fact we wish to 
emphasize here is that the converse of these propositions is, of 
course, equally true. Whatever may be affirmed of demand 
prices may also be affirmed of significance or utility. Hence 
if in a later chapter we find that a given demand price has a 
certain effect upon normal price, we shall be able to say that 
the utility or significance corresponding to that demand price 
has the same effect. 



262 PRINCIPLES OF ECONOMICS 

I will now close this discussion of normal demand sched- 
ules with a statement regarding their general character. Gen- 
erally speaking, all normal demand schedules are of the kind 
which in the chapters on Immediate Price-Determination were 
characterised as typical. Doubtless this must be affirmed less 
roundly of some than of others. A few are relatively inelas- 
tic, for example, those of the prime necessaries of life ; but, 
over a wide range of prices all these schedules show fairly 
uniform changes in demand with every material change in 
price. This fact, as we may easily see, is quite inevitable. ( i ) 
General schedules are composites of numberless individual 
schedules. (2) The tastes and wants of individuals differ 
greatly. (3) Most of all, the incomes of individuals are very 
unequal. As a result, there will be some effective demand at 
almost every price level. Even at very high levels, those who 
are rich and wish a commodity intensely will continue to de- 
mand it ; while, with each fall in price, some persons who care 
less or have smaller incomes or who fulfill both these condi- 
tions will come in with a new demand. The general schedule, 
as a whole, therefore, will show a high degree of continuity, 
regularity, and symmetry. 

We may now summarize the contents of this chapter in 
the following propositions : ( i ) the marginal demand price 
of the individual schedule for a given quantity of any com- 
modity is an expression of the marginal significance as esti- 
mated by himself of that quantity of said commodity. (2) The 
marginal significance of that quantity of said commodity, in 
turn, is determined by its marginal utility as estimated by the 
individual concerned. (3) The marginal utility of any com- 
modity, and hence its marginal significance and its marginal 
demand price, vary inversely as the quantity bought. (4) 
Whatever principle may properly be affirmed with respect to 
the influence of demand prices on actual price can properly be 
affirmed also of significance or utility. (5) General demand 
schedules are highly elastic, and therefore of the kind called 
typical. 



262 PRINCIPLES OF ECONOMICS 

INSERT, p. 262 

IL1.USTRATIVE Problems. 

1. "All talk about normal price is simply silly. There isn't any such 
thing. The economist teaches that normal price corresponds to cost of 
production ; whereas every one knows that, during the last two or three 
years, (written in 1918), the prices of almost all commodities have been 
far above cost of production." 

Is his reason for denying the existence of normal price valid? Explain. 

2. One of the possible upper limits of the actual price of any com- 
modity is its marginal utility or significance; while one of the possible 
lower limits of that price is the first extra-marginal utility or signficance 
of said commodity. 

Give the argument needed to support those propositions. 



CHAPTER XVII 

NORMAL SUPPLY SCHEDULES 

In the preceding chapter we considered various topics pre- 
liminary to the study of normal price, including normal de- 
mand schedules. In this chapter we continue the study of 
preliminaries, especially matters connected with supply. 

The supply schedule with which we were concerned in our 
first study of the processes of price-determination is most nat- 
urally designated the market supply schedule. In that sched- 
ule we are looking at the immediate attitude of sellers. At 
a certain time, for a great variety of reasons, sellers are ready 
to sell a certain number of units of a commodity if price is 
so and so, another number if price is something else, and so 
on. This attitude of sellers is a momentary one,^an ever- 
changing one. If they hear a little different news as to con- 
ditions in other markets, the probabilities of demand in some 
other community, or the success of production during the cur- 
rent season, they will alter their supply schedule, will change 
the quantity they are willing to sell at any particular price. 

We wish now on the other hand to study the attitude of 
sellers throughout a longer period. During a season, a year, 
or a series of years, sellers are acted upon by certain larger 
and more permanent forces, and under the influence of those 
forces, they stand ready to sell a particular number of units 
of a commodity if price is so and so, another number if price 
is something else, and so on. This attitude of sellers is rep- 
resented in the normal or long-time supply schedules. As a 
final preliminary to our study of actual normal price and its 
determination, we must now investigate the nature of these 
normal supply schedules. 



264 PRINCIPLES OP ECONOMICS 

Section A. The Cost o£ Production 

In taking up the study of supply schedules, our first task, 
as it was in the study of demand schedules, is to acquaint 
ourselves with the deeper elements which lie behind them. 
Now for the majority of producible goods, the most signifi- 
cant of the elements determining the supply schedule is cost 
of production. We begin, then, with a brief discussion of 
this topic. 

For our present purposes it is necessary to distinguish two 
kinds of costs: (i) real or disutility costs, meaning the per- 
sonal, psychic discomforts necessarily accompanying some 
productive acts, for example, the weariness resulting from 
labor, and (2) opportunity costs, meaning the other economic 
advantages foregone because we decide to devote our produc- 
tive resources to supplying the particidar economic good in 
question. Now the bearing of these costs ultimately rests, 
in a very important sense on one agent in production — the en- 
trepreneur — since he is preeminently responsible for the initia- 
tion and continuance of any industrial process, purchasing 
from other agents the services of their factors and uniting 
them for the production of a common commodity. Accord- 
ingly, it is cost as viewed by the entrepreneur which primarily 
interests us here. From this standpoint, we include under cost 
everything entering into the productive process zvhich has a 
price, or which will not be furnished unless it is covered in 
the selling price of the product. 

The greater part of the entrepreneur's costs are money 
costs or, as they are often called, expenses. These comprise the 
actual money outlay which the entrepreneur is compelled to 
make in order to get the elements needed in his business. For 
labor he of course has to pay wages. This calls for no com- 
ment except in one point that might be overlooked. The term 
wages must be interpreted to include any sum the entrepre- 
neur allows himself for labor which he might buy but which, 
in fact, he himself supplies. If he works as manager, or 



NORMAL SUPPLY SCHEDULES 265 

bookkeeper or clerk, he allows himself a money recompense, 
and this must properly be reckoned as wages. Secondly, for 
the use of land, the entrepreneur must make a money pay- 
ment, called rent. There has been, and continues to be, con- 
siderable controversy as to whether, in the final analysis, rent 
ought to be thought of as a true cost. But, from our present 
standpoint, there is no room for doubt on the subject. The 
individual entrepreneur must treat his outlay for the use of 
land, like any other, as one of the expenses of carrying on the 
business. Finally, the entrepreneur has to pay for the use 
of capital a money expense known as interest — including not 
only the sums paid out to others from whom any part of his 
money capital is borrowed, but also sums credited to himself 
on any capital which he has himself put into the business. All 
of these outlays, wages, rent and interest, plainly come under 
our definition of entrepreneur's costs ; for the entrepreneur 
is compelled to make them before he can produce — and usual- 
ly before production can be commenced — and accoirdingly 
unless something were added to the price of the product to 
cover them he would lose money and be forced to withdraw 
from business. 

Besides the money costs of production there is the real 
cost, risk, which the entrepreneur himself undergoes in fur- 
nishing his own peculiar contribution. Responsibility Taking. 
The reason this is not represented in the classification just 
finished, by a money cost, is easily seen. From the very na- 
ture of Responsibility Taking it cannot be sold to any one of 
the four agents : the entrepreneur cannot sell it to himself, be- 
cause that would be a contradiction in terms ; nor can he 
sell it to the laborer, landlord, or capitalist, because he would 
thereby become a hired laborer or capitalist, and they, in so 
far as they paid him for taking responsibility, would really 
be taking the original responsibility themselves. In short, the 
entrepreneur's risk remains a real cost, in distinction from 
the money costs listed above. Risk does, however, easily 
come under our definition of entrepreneur's costs as some- 



266 PRINCIPLES OF ECONOMICS 

thing which has to be covered by an addition to the price of 
the finished product. While the entrepreneur takes risks, he 
by no means takes them for nothing; his risk must have an 
objective expression in some kind of money payment, or he 
could not be induced to undergo it. So, a sum is added to the 
price of the finished product tO' cover risk, and when received 
by the entrepreneur it is called profits. 

Besides the four costs thus far enumerated, there is an- 
other of rather troublesome complexity. In addition to in- 
terest on money capital, the entrepreneur has of course to 
pay the purchase price of any capital goods — machinery and 
raw materials, — which he may use in his business. As a mat- 
of fact this is not a new cost distinguishable from those al- 
ready mentioned. A capital good represents in a rough way 
the real and money costs that went into it in the past, and it 
is for these that the purchase price is paid; in other words. 
in addition to current costs, the entrepreneur pays for wages, 
interest, etc., brought down from the past. However, the 
price he pays for a capital good has often departed more or 
less from the price which expressed its real cost, and so we 
cannot use the latter as an equivalent of its cost in the cur- 
rent productive process. But, anyway, the entrepreneur never 
thinks of analyzing these goods into their ultimate costs. Their 
present market value is what concerns him, and since it is 
entrepreneur's costs of which we are speaking, it is best to 
conceive them simply as an undistributed element in his money 
outlay. The total entrepreneur's cost may be summarized in 
the following tabular form. 

Entrkpreneur's Cost 

I Money Costs 

1. Actual Outlay 

2, Market Value of Purchasable 

Services of Entrepreneur 
II Money Expression of Disutility Cost of 
Unpurchasable Services of Entrepreneur 



NORMAL SUPPLY SCHEDULES - 267 

It doubtless ought to be added, in concluding this topic, 
that the cost referred to is supposed to be in all cases the cost 
to representative producers. On the one side, we exclude the 
cost of a few specially inefftcient producers, and on the other 
sid-s the very low cost of a few specially favored producers. 
The situation of the former is frequently such that some of 
his costs do not necessarily have to be covered by an addi- 
tion to price; the price may be below his cost and he will go 
on producing anyway, until death or bankruptcy intervenes. 
The favored producer, again, may, for various reasons, find 
his costs very much more than covered by additions to the 
price. Neither of these, therefore, furnishes a proper exam- 
ple of entrepreneur's costs. The cost to be understood in this 
discussion is the cost to normal, typical, representative pro- 
ducers. 

Section B. Normal Supply Schedules 

With the information set forth above, we may now re- 
turn to the examination of normal supply schedules. We said 
that the cost of production was the determining factor be- 
hind most of these schedules, and we have now explained 
that the cost referred to is the entrepreneur's cost, for typi- 
cal representative producers. Keeping this definition in mind, 
therefore, let us now observe the cost elements behind the 
stock or output of dififerent kinds of goods, then observe what 
determines the amount of the stock or output which will pass 
into supply at any given price and, finally, note the charac- 
teristics of the dififerent kinds of supply schedules thus 
formed. 

I. Fixed-Supply Goods and Their Schedules 

The first kind of good is one the stock of which — meaning 
by stock the total amount in existence — is not afifected at all 
by the cost of production. This is true simply because in 
the long run, or at least during the period under considera- 
tion, no additional units of the good can be produced. One of 
the most typical of such goods is one Avhich is entirely non- 



268 PRINCIPLES OP ECONOMICS 

producible — man cannot make it — and which at the same time 
is practically indestructible — man cannot destroy it or, any- 
how, acting normally, luill not. The uses of land will illus- 
trate, or land itself ; for within the area of any city there are 
just so many sites of a particular grade which, broadly speak- 
ing, no human action can increase or diminish. Another sort 
of good answering our description is one produced by persons 
no longer living, as for example, pictures by Raphael or auto- 
graphs by Milton. But a producible good may also at times 
fall into the same class. Thus, when a hat or similar article 
goes out of style, the amount then in existence will never be 
increased. A periodically produced good, again, has an un- 
changeable stock for the interval between two periods of pro- 
duction; thus, the stock of wheat in the world cannot change 
during the year 1918, because no more wheat can be produced 
until the year 19 19. In a word, it may be said of all these 
kinds of goods that the stock is what it is and for all time, or 
for the period under consideration, must remain what it is, 
unaffected by any cost of production — because production does 
not take place, production is impossible. 

Under these conditions, what will determine the amount 
oi the unchanging stock which will pass into supply at any 
given price? Observe first that supply, the amount offered for 
sale, at some price must sooner or later include the whole of 
the stock. If a dealer has ten Rembrandt pictures, or a dozen 
city lots, or a gross of out-of-style hats, these articles are 
bound in the course of months or years or centuries to pass 
into supply. Substantially the whole output of wheat for this 
season is bound to be disposed of before the next harvest, and 
so before that time will assume the status of supply — at some 
price or other. But further, this will be true no matter what 
the price. Under competitive conditions, the owners of the 
land sites used in the illustration will see to it that all the sites 
are rented, even if they have to take $1.00 a year. Practi- 
cally the whole of a wheat crop will be marketed before the 
ensuing harvest, even if it has to go for $.50 a bushel. Hence, 



NORMAL SUPPLY SCHEDULES 269 

the thing which determines the supply at any given price, as 
well as at some price, is simply the total stock. 

With the information now before us we may easily note 
the chief characteristics of the supply schedules of the kind 
of goods under consideration. First, strictly speaking, these 
schedules show no supply prices at all ; there are no prices 
on which the forthcoming of supply is conditioned — supply 
will be such and such whatever the price. Hence in any for- 
mula of price determination where we would ordinarily use 
the phrase "supply price," we may just as properly use the 
word "supply." Moreover, since supply includes the total 
stock, in any formula containing the word "supply" we may 
substitute the word "stock." 

The second characteristic of our schedules is not less eas- 
ily shown. Supply being equal to stock, and stock being by 
hypothesis non-increasable, therefore supply is fixed. The good 
in question is what we call a fixed-supply good. But a fixe^- 
supply good must necessarily have a supply schedule which 
shows supply remaining constant through all changes in price. 
To illustrate : Supposing ten to be the total number of land 
sites of a certain grade, a section of the ultimate supply sched- 
ule will run as follows : 

Price Supply 



>2,000 


ID 


1,900 


10 


1,800 


ID 


1,700 


ID 


1,500 


10 


1,200 


10 


.900 


10 



2. Constant-Cost Goods and Their Schedules 

The second kind of goods, as classified from the stand- 
point of the cost of production, is what we call constant- 
cost goods. These goods are of such a nature that virtually 



270 PRINCIPLES OF ECONOMICS 

none at all can be produced below a certain cost; but at that 
cost the output can vary widely, falling rather low, perhaps^ 
or rising to an amount which, in view of demand conditions, 
may fairly be called indefinite. Such a description is of course 
not quite true of any commodity, but it is at least substan- 
tially true of many kinds. A manufacturer of wooden chairs, 
for example, so long as he kept his output above 500,000 and 
did not attempt to increase it above 5,000,000 might find that 
the cost of the chairs neither decreased nor increased through- 
out that range, but remained constant. But since this range 
is as great as his output is likely ever to traverse, the chair is 
in effect a constant-cost commodity. 

Now, if none of the goods at all can be produced at a cost 
lower than the one stated, and if an indefinite amount can be 
produced at that cost, what will determine the amount of sup- 
ply forthcoming at any given price? We may assume, natur- 
ally, that the entire output will be offered at some price ; pro- 
ducers have no other object in producing than to offer their 
goods for sale, and accordingly, supply at some price or other 
will include all their output. Second, producers will offer of 
their output an indefinitely large amount at a price just equal 
to the cost of production, — including, remember, a reasonable 
profit, — for the larger their output the larger will be their 
profits. Further, no more will be offered at prices higher 
than cost, since an indefinitely large amount is by the very 
name declared to be non-increasable. On the other hand, if 
price were to go below cost of production, producers would 
lose ; and hence at prices below this cost of production, supply 
will be zero. In short, there will be an indefinite amount of- 
fered at prices equal to cost of production, no more at prices 
above, and none whatever at lower prices. The forthcoming of 
supply is thus in every case dependent upon a price equal to 
the cost of production. 

The foregoing information should enable us now to de- 
scribe without difficulty the supply schedules of constant-cost 



NORMAL SUPPLY SCHEDULES 271 

goods. First, as we have plainly implied, the factor or ele- 
ment in the background determining the supply price of the 
commodity is the cost of producing that commodity. Any 
particular supply price is what it is because the cost of pro- 
duction is what it is. Accordingly, if we find that the supply 
price plays an important part in determining actual normal 
price for goods of this class, we also necessarily find that the 
cost of production plays this same part. Whenever, in short, 
we have a proposition affirming a certain relation between 
normal price and supply price, we can substitute in such prop- 
osition for the phrase "supply price" the other phrase, "cost 
of production." 

Second, if throughout the supply schedule for constant- 
cost goods there will be an indefinite amount offered at prices 
equal to the cost of production, how will the supply prices 
vary? They will not vary at all. Cost of production, as we 
have seen, is, within any range which demand is likely to 
traverse, a constant, unchanging cost. But a supply price equal 
to an unchanging cost will be an unchanging price. Hence, we 
say that the supply schedule for constant-cost goods is a single 
price supply schedule. 

3. Increasing-Cost Goods and Their Schedules 

The third kind of goods, classified from the standpoint of 
the cost of production, is known as increasing-cost goods. By 
these we mean goods the marginal cost of which increases as 
the output is increased : the cost of each additional unit is 
greater than that of the last unit added before. This class of 
goods is well represented by silver, copper, wheat, cotton, and 
many other of our most familiar and important commodities. 

The technical consideration that usually determines wheth- 
er a good will be one of constant-cost or one of increasing- 
cost is the relative proportions of naturally limited materials 
necessary for its production. If the cost of a good lies mainly 
in the manufacturing process or in raw materials which, un- 
der ordinary conditions of demand, are practically unlimited, 



272 PRINCIPLES OP ECONOMICS 

then the cost per unit of the amount produced will remain 
constant. Thus the chair of our last illustration is supposed 
to be made from a wood which is common and abundant, 
and to be manufactured by simple processes easily and plen- 
tifully supplied with machinery and labor. Examination of 
the steel, or copper, or coal industry, however, reveals quite 
a different situation. Here a large part, if not the largest 
part of the cost belongs to the raw materials as they are got- 
ten out of the mines. But the supply obtainable from mines 
of a uniformly best grade is decidedly limited. Hence, as de- 
mand increases, and the need steadily grows for heavier pro- 
duction, resort must be had to inferior mines — mines more and 
more inferior — and so the cost of production will steadily in- 
crease. 

Here again, as in the case preceding, we start with the as- 
sumption that whatever is produced is produced for supply, 
and that therefore output and supply — supply at some price — 
are virtually one. The question of what determines supply, 
the quantity offered at any given price, is then easily answered. 
Men can produce and will therefore supply an indefinite 
amount at a price equal to the marginal cost of production, 
because the larger their output the larger will be their profits. 
They will supply none at a price below this marginal cost, be- 
cause if they did they would lose money. Nor, again, will 
they supply any at a price higher than this marginal cost of 
production. They would of course be glad to do so, in order 
to increase their profits ; but since they can offer and are 
willing to offer an indefinite amount at the marginal cost 
price, competition among them will insure offerings at that 
price as great as demand can absorb. Evidently, then, if an 
indefinite amount will be offered at a price equal to the mar- 
ginal cost of production, none at prices below that, and no 
more at prices above, the thing which determines the forth- 
coming of stipply in every case is a price equal to the mar- 
ginal cost of production. 



NORMAL SUPPLY SCHEDULES 



273 



Let us now examine the supply schedules of increasing- 
cost goods. First, since the marginal cost of production is the 
factor or element behind the scenes which determines the sup- 
ply price for any particular volume of the commodity ; since, 
in other words, the supply prices of the schedule are merely 
so many marginal costs : — the schedule itself may be inter- 
preted either as a supply schedule or as an output-cost sched- 
ule, that is, a schedule showing just how much of the com- 
modity in question could be produced at a marginal cost equal 
to each of a series of prices. It follows that, in any formula 
of price determination containing the phrase "marginal sup- 
ply price," we can properly substitute the phrase, "marginal 
cost of production." 

Second, if throughout the schedule the amounts offered 
are all offered at a price equal to the marginal cost of produc- 
tion, then the prices must vary in the same direction as the 
supply. The marginal cost of production for goods of this 
class is, as we have seen, one which varies directly as the out- 
put or supply, it is an increasing cost. But a supply price 
equal to an increasing cost will be an increasing supply price. 
Accordingly, we say that the supply schedule for an increas- 
ing-cost commodity is an increasing-price schedule. 

Still a third feature of the supply schedules of increasing- 
cost goods should be observed. The schedules are of the kind 
which we earlier called typical. Over a wide range of prices, 
they show fairly uniform changes in output with every mate- 
rial change in price ; in other words, they are highly regular 
and symmetrical. This is inevitable from the conditions of 
production. When we consider that the natural factor in pro- 
duction, the land, varies greatly with respect to natural fer- 
tility and advantage of situation, and that individuals are of 
all degrees of efficiency, it is plain that costs of production for 
goods of this class will be of almost infinite variety. This, of 
course, will make the supply prices, the prices on which the 
forthcoming of supply is conditioned, equally diverse. 



274 



PRINCIPLES OF ECONOMICS 



4. Variable Schedules 



In concluding this discussion of supply schedules we should 
observe the tendency of some goods to shift from one class 
to another, to have this year one kind of supply schedule and 
next year a different kind. A good which under ordinary cir- 
cumstances belongs to the constant-cost class might some- 
times be conceived of as running into the increasing-cost or 
even the fixed-supply class. Thus, in normal times of peace 
agricultural implements belong to the constant cost class ; there 
is a price below which none will be supplied, and at that same 
price an amount will be supplied which in view of the then 
existing condition of demand, may fairly be called indefinite. 
But suppose a great war commences and demand is suddenly 
increased far beyond what was formerly considered an in- 
definite supply. Then, in order to keep pace with the demand, 
new sources of material for the supply must be resorted to, 
particularly new mines. But these mines, though furnishing 
the metal required, are inferior to those formerly worked, and 
so furnish it at an increasing cost. Hence the implements, the 
production of which depends upon these mines, can be sup- 
plied only at an increasing cost, and they become increasing- 
cost goods. Further, it should be very easy to see that if de- 
mand altogether outran supply, if it became so great as com- 
pared to supply that additions to supply were inappreciable, 
then the goods would cut loose from cost principles altogether, 
and become virtually a fixed-supply good, or at any rate a 
good with a fixed-supply schedule. 



CHAPTER XVIII 

PRINCIPLES GOVERNING THE DETERMINATION 
OF NORMAL PRICE 

In the two preceding chapters we have discussed normal 
supply schedules, with the costs of production which he back 
of them, and normal demand schedules, with the signifi- 
cances to consumers which lie back of them. It is through 
these normal supply and demand schedules that the normal 
prices of goods are determined. We are now, therefore, in 
a position to take up the direct study of those principles 
which are commonly given as governing normal price. 

We shall treat in succession the three classes of goods 
named in the last chapter — fixed-supply goods, constant- 
cost goods, and increasing-cost goods. By this process 
we can handle methodically all problems of normal price 
determination; for the three classes of goods named have 
their normal prices determined in three different ways, and 
those three ways include practically all the ways, and in- 
deed quite all the most important ones, in which normal 
price can be determined. 

Speaking generally, we may say that the goods of one 
class have their prices determined from the demand side only 
— through the prices of the demand schedule ; that goods of 
the second class have their prices determined from the sup- 
ply side only — through the prices of the supply schedule; 
and those of the third class have their prices determined by 
elements from both demand and supply — through both the 
demand and the supply schedules. In section A, following, 
we begin with that class the prices of which are determined 
from the demand side only. 



276 PRINCIPLES OF ECONOMICS 

Section A. Normal Price of Fixed-Supply Goods 

We will take as an example of fixed-supply goods copies 
of the Basel edition of Sir Thomas More's Utopia. Suppose 
that, at about the same time in the year 1925, three or four 
finds are made, bringing on the market a new supply of these 
books amounting to ten copies. Suppose, further, that the de- 
mands of libraries and private collectors are such that the 
aggregate demand schedule is as follows: i copy wanted, if 
price is $200; 2 copies, if price is $175; 4 copies, if $160; 6 

copies, if $125 ; 10 if 
$100; II, if $90; 14, if 
$75 ; and so on. Under 
these conditions, what 
must the price tend to be, 
and what principles will 
regulate that price? The 
accompanying demand and 
supply schedule shows that 
the price could not be 
above $100; for, if it went 
above this figure, 4 buyers 
would withdraw, making 
demand deficient, and, in order to guard against this 
result, the sellers would bring price down to $100. On the 
other hand, price could not go down to $90; since, if it did, 
one new buyer would come in, making demand excessive, a 
result which $ioo-buyers would have to guard against by bid- 
ding price up to at least $91. Actual price, then, must tend to 
be some price between $91 and $100, inclusive. 

The first and most obvious comment on this case is that 
our familiar law of supply and demand is still operative. A 
price must be reached at which demand and supply are equal. 
If demand and supply were not quite equal at one of the 
prices given in the schedule, the necessary equating would be 
effected in practice by compromise prices between those giv- 



emand 


Price 


Stoci 




dollars 




I 


200 


10 


2 


175 


10 


4 


150 


10 


6 


125 


10 


10 


100 


10 


II 


90 


10 


14 


75 


10 


16 


60 


10 


20 


50 


10 



NORMAL PRICE DBTURMINATION 277 

en. Equality of demand and supply would be reached at 
$95 or $94 or $97 or at some other figure between $90 and 
$100. Further, it is manifest that the law of supply and de- 
mand is regulating not merely market price but normal price 
also. The market price, under this law would in successive 
hours or days or weeks probably run both above and below 
$100, perhaps mostly above. But under the same law, as a 
final resultant, a normal price of $100 would be affirming 
itself. 

We have noted that, in this case of fixed-supply goods, 
the law of supply and demand is still operative and is deter- 
mining normal price. It may be worth while to add that the 
law may here be affirmed in a somewhat special sense. Since 
supply is, by hypothesis, constant and so demand must do all 
the changing; and since supply is in the long run identical 
with stock, we are justified in restating the principle as fol- 
lows : In the case of fixed-supply goods, the normal price 
must tend to he that price or some one of that series of prices 
which will cause demand to become equal with the unchang- 
ing supply. Or, more briefly, the normal price must tend to 
he that one or some one of that series which will equate de- 
mand to stock. 

The natural procedure, in seeking a deeper knowledge 
of the processes by which normal price is determined, is to 
note first the relations between the price which is necessary 
to equate supply and demand and the prices which we learned 
in Chapter XIV to designate supply prices and demand 
prices. Among those prices, we will remember, the immedi- 
ately effective ones in the regulation of price through sup- 
ply and demand were the marginal demand price and the 
first extra-marginal supply price for the upper limit of 
price and the marginal supply price and the first extra-mar- 
ginal demand price for the lower limit. Are all of these oper- 
ative in the case of fixed-supply goods : and if not, which 



278 PRINCIPLES OF ECONOMICS 

ones are ? The answer is quickly given : only the demand price 
limits are operative. 

As we saw in our first analysis of the Utopia example, at 
least one reason why normal price could not be above $ioo 
is that, unless price is as low as $ioo, the last increment of 
demand will not appear at all, and sellers, therefore, will be 
obliged to bid actual price down to $ioo to insure disposal of 
the stock. That one of the two variables fixing the upper lim- 
it of price which comes from demand, the marginal demand 
price, is thus actually operative. But the other variable fix- 
ing this limit, the one which comes from supply, is not opera- 
tive. Sellers are not compelled to bid price down in order 
to prevent the appearance of a new supply ; for there is no 
new supply to appear — supply is constant. In other words, 
the first extra-marginal supply price has no share in fixing 
the upper limit of actual price. That limit is fixed by the 
marginal demand price only. 

Turning, now, to the lower limit of price for this same 
commodity, it is evident that actual price could not go down 
to $90 because this would make demand increase by one copy, 
thus compelling buyers to bid price up to some higher figure 
in order to exclude this increment of demand. But, on the 
other hand, buyers do not have to hold price up in order to 
keep in the marginal supply; for, by hypothesis, supply is 
constant and therefore will not fall with a decHning price. 
In short, that one of the variables fixing the lower limit of 
price which comes from demand — the first extra marginal de- 
mand price — is the only one actually operative. From this 
analysis, it follows that, in the case of fixed-supply goods, the 
normal price must be one of the prices ranging from a limit 
fixed by the marginal demand price, and that only, down to 
a limit fixed by the first extra-marginal dewrand price, and 
that only. 

The above formula confines itself to defining the limits 
within which normal price must tend to fall. But, as already 
noted, actual demand schedules for most commodities are 



NORMAL PRICE DBTBRMINATION 



279 



continuous, — show changes in the volume of demand for 
practically every change in price. In consequence, the mar-- 
ginal and the first extra-marginal demand prices will be in 
such close juxtaposition that actual price cannot go below 
the marginal demand price at all without reaching the first 
extra-marginal demand price. In practice, then, it will usu- 
ally be sufficient to define normal price by one of these lim- 
iting moments, the marginal demand price. Hence the fol- 
lowing formula. 

Principle. Generally speaking, the normal price of a 
fixed-supply commodity must tend to coincide with its mar- 
ginal demand price. 

The formula just given makes the marginal demand price 
the decisive factor in determining the normal price of fixed- 
supply goods. But as was explained in Chapter XVI, the 
marginal demand price must usually be an expression of the 
marginal significance to the marginal buyer, as estimated by 
himself, of the quantity of a commodity he proposes to buy ; 
and this, in turn, must be determined by his estimate of \he 
marginal utility he expects to derive from that quantity of 
the commodity. Further, the marginal significance or utility 
to the marginal buyer is the general marginal significance or 
simply the marginal significance. And, finally, in any formula 
containing the phrase "marginal demand price," we can sub- 
stitute the phrase "marginal significance" or the phrase "mar- 
ginal utility." Hence the following formula. 

The Marginal Significance or Utility Principle 

Generally speaking, the normal price of a fixed-supply 
commodity must tend to he that price which expresses the 
marginal significance or utility of the existing stock of said 
commodity. 



28o PRINCIPLES OF ECONOMICS 

Tl,I,USTRATlVE PrOBL^^MS 

1. During the current year, there came on the market 
from various sources twelve specimens of a certain rare ob- 
ject. If the ultimate demand schedule proves to be as fol- 
lows : I wanted at $60; 2 more at $55 ; 4 more at $50; 5 more 
at $45 ; 6 more at $40 ; etc., what price will in the long run 
tend to be reached? Prove. 

2. In a certain year the output of wheat proved to be 
2,000 millions of bushels. The ultimate demand schedule for 
the year ensuing till the next harvest was as follows: 1,600 
mil. bu. wanted if price were $1.30; 1,800 mil. if price were 
$1.25; 2,000 mil. if $1.20; 2,200 mil. if $1.15; and so on. 

(a) What price would tend to prevail for that year? 
Prove in detail. 

(b) What would determine it? 

(c) What price would tend to prevail, if the demand 
moved up a step, making the schedule 1,800 mil. at $1.30; 
2,000 mil. at $1.25; 2,200 at $1.20; 2,400 at $1.15; and so on? 

(d) What price if demand moved up two steps, making 
the schedule: 2,000 mil. at $1.30; 2,200 at $1.25; and so on? 

(e) What price if demand moved down two steps, mak- 
ing the schedule: 1,200 mil. wanted at $1.30; 1,400 mil. at 
$1.25; 1,600 at $1.20; 1,800 at $1.15; 2,000 at $1.10; and 
so on? 

3. "In 1348-49 the black death carried off from one- 
third to one-half of England's workingmen. In consequence 
wages greatly advanced." 

(a) Explain the advance in wages on the basis of the 
Law of Supply and Demand given on page 244, constructing 
for the purpose imaginary demand and supply schedules. 

(b) Explain the advance in wages on the basis of the 
Marginal Significance principle given above. 

(c) Discuss this statement: "Wages rose because the 
demand for the laborers who were left had greatly increased." 



NORMAL PRICE DETERMINATION 281 

Section B. Normal Price of Constant-Cost Goods 

In sharp contrast with the class of goods just considered, 
fixed-supply goods, are the constant-cost goods with which 
we now deal. The former had no supply price, or perhaps 
better, their supply price was indeterminate. Constant-cost 
goods, on the other hand, have just one supply price. Within 
the limits of the demand likely to develop, an indefinitely 
large supply will be forthcoming at that one price, while 
none will be forthcoming at any lower price. 

Under this condition, the principle governing normal price 
is readily derived. As we found in Chapter XIV, the limits 
of price variation may be fixed by two prices from the de- 
mand side, by two prices from the supply side, or by a com- 
bination of these. Now, in the present case, the two limiting 
prices on the side of supply — the marginal and first extra- 
marginal, coincide. That price is necessary to the forthcom- 
ing of any supply, and it will also bring out a quantity which, 
in view of the volume of demand, is indefinitely great. The 
other moments which might fix the limits of price variation, 
marginal and first extra-marginal demand prices, may there- 
fore be ignored. These other limits may coincide with those 
fixed by the supply price. But, even if they do not, even if 
they vary indefinitely, they will not tend to alter an actual 
price which is anchored to a single supply price. A qualifi- 
cation of this statement may seem necessary, from the fact 
that there must be some demand at a price as high as the sin- 
gle supply price ; or, to put it the other way, actual price could 
never be higher than the marginal demand price. But this 
simply means that, if the marginal demand price were not as 
high as the single supply price, the commodity would not be 
produced at all, and hence no problem of its price determina- 
tion would arise. It is sufficient, then, to say that the nor- 
mal price of such a com_modity must tend to coincide with 
the single supply price without respect to demand prices.* 



* With the single qualification just noted. 



282 PRINCIPLES OP ECONOMICS 

The principle just brought out, the exclusive dependence 
of constant-cost goods on the supply price, is so important 
that it seems best to give it the benefit of ample illustration. 
We will take for the purpose, a wooden chair. This commodity- 
is a constant-cost good at the single price of 30 cents so long as 
demand is not less than 500,000 and not greater than 2,000,000. 
The accompanying table shows the supply schedule for this 
range of demand, and various possible demand schedules. Since 
producers who are ready to supply anything between the 
amounts named at 30 cents will of course be willing to do the 
same at any higher price, we give 500,000-2,000,000 for every 
price from 30 cents up. Below that price demand is each time 
zero. 

Combining the supply schedule S with demand schedule 
A, it is plain that price must tend to be just 30 cents. Price 
could not be higher than this ; since sellers, being ready to 
supply much more than the total amount demanded at 30 
cents, will bid down to that figure in order to get as much of 
the market as possible. On the other hand, since there is no 
supply forthcoming at prices below 30 cents, buyers will 
bid price up to that figure to insure getting what they want. 
Exactly similar reasoning would show that the price must 
necessarily tend to be just 30 cents with demand schedule B 
or C or D or, in fact, with any one we could imagine which 
made demand at 30 cents more than 500,000 and less than 
2,000,000. 

But not only will price be 30 cents, the single supply price, 
it will rest at that point uninfluenced by demand prices."^ The 
most clearly decisive proof of this assertion is to be found in 
the fact that the same price would be reached if our demand 
schedule were so altered as to put the demand prices which 
might influence the matter quite outside the price bound to 
prevail. Thus, let us suppose the Schedule D to be so changed 
that from 50 cents to 15 cents there is no change in the vol- 



* Remember, however, the qualification already noted. 



NORMAL PRICE DETBRMINATION 283 

ume of demand. Now, under this schedule as under the 
others, normal price must tend to rest at 30 cents ; buyers will 
hold it up to this point ; sellers will hold it down to this point. 
But with a normal price of 30 cents, the marginal demand 
price for schedule D would have to be 50 cents, since that 
price is low enough to bring in the whole demand actually- 
satisfied; while the first extra-marginal demand price would 
have to be 15 cents, since no addition to demand takes place 
till this price is reached. But neither of these prices influ- 
ences a price set at 30 cents. A marginal demand price of 
50 cents would permit actual price to rise to 50 cents ; while 
a first extra-marginal demand price of 15 cents would permit 
actual price to fall as low as 20 cents. But, in fact, actual 
price cannot rise above 30 cents, nor fall below 30 cents. Its 
position, therefore, is uninfluenced by the demand prices. 



SUPPLY 


price; 
Dollars 




DE^MAND ( 


000 




Sch. S 000 


Sch. A 


Sch. B 


Sch. C 


Sch. D 


Sch. E 


500-2000 


3 


2 


3 


3 


5 


5 


500-2000 


2 


10 


12 


15 


20 


20 


500-2000 


I 


50 


51 


60 


80 


80 


500-2000 


75 


300 


500 


810 


1 100 


1 100 


500-2000 


•50 


500 


750 


1020 


1400 


1400 


500-2000 


.40 


600 


895 


1200 


1520 


1400 


500-2000 


■30 


700 


950 


1540 


1840 


1400 





•25 


1000 


I2I0 


2000 


2560 


1400 





.20 


1500 


1800 


2560 


2800 


1400 





.15 


2500 


3000 


3800 


4563 


2000 



We are now in a position to observe the final results of 
our study of constant-cost goods. These goods, we have just 
shown, must tend to have a price coincident with their sin- 
gle supply price, uninfluenced by their demand prices. But 
that single supply price, as we learned in the chapter on sup- 



284 PRINCIPLES OF ECONOMICS 

ply schedules, is the cost of production to the representative 
producer; and demand prices, as we learned in the chapter on 
demand schedules, are expressions of the marginal signifi- 
cance or utility of the commodity to marginal consumers. 
Making the substitution of terms, therefore, we may say that 
the price of a constant-cost commodity tends to coincide with 
its cost to representative producers, uninfluenced by the sig- 
nificance or utility of the commodity to consumers.* 

The result of the preceding discussion has been to set up 
cost of production as the determinant of the normal price of 
constant-cost goods. However, a word of caution is here 
necessary. The power of cost to determine price is derived 
from its power to influence the forthcoming of supply. Its 
influence, therefore, is exercised through the future rather 
than the past. It is not because the existing product had a 
cost that price has to equal cost, but because the future out- 
put "mill have a cost. From this fact it results that unless 
there is call for future production, cost can have no influence 
on price. If, for example, a change in fashion makes the ex- 
isting stock of a particular style of shoe in excess of any 
possible demand at a price as high as cost, there will obvi- 
ously be no need for further production, and so cost will have 
no influence on the price. Such a commodity will, as seen 
in our classification of commodities, pass into the class of 
fixed-supply goods. Its price will then become purely a mat- 
ter of demand prices and, therefore, of the forces lying be- 
hind those prices, namely, significance or utility. To insure 
our recognition of this point, our principle will explicitly state 
that the continued production of the commodity in question 
must be called for. 

Another caution is suggested by the consideration on which 
the last was based, — that cost of production acts only through 
its relation to future product. Cost of production may 
change, rise or fall ; and, after every change, it will be the new 



* Remember the qualification. 



NORMAL PRICE DETERMINATION 285 

cost which must determine price. To anticipate this difficulty, 
some writers have argued that we ought to say "price must 
equal cost of reproduction." To this, however, the answer 
of Cairnes is perhaps sufficient : all scientific principles assume 
constancy of conditions ; the cost which is decisive at any 
period is the cost of that period, conditions supposed to be 
unchanged. But, if any one prefers, there is no serious objec- 
tion to saying cost of reproduction. 

The principle brought out in this discussion may now be 
formulated as follows : 

Principle. The normal price of constant-cost goods, the 
continued prodttction of which is demanded, must approxi- 
mately equal their cost to representative producers. 

Il,I.USTRATlVE PrOBLE^MS 

1. From a cement factory promoter in 1901 : "We can 
easily satisfy any fair-minded person that our proposition is 
a veritable gold mine. Cement can be put on the market by a 
well-equipped mill at a cost of about $1.75 a barrel, while it is 
selling for $4, thus giving a profit of over 100 per cent. With 
the supply of raw material practically unlimited, our mill will 
soon be turning out 600,000 barrels per year, and our annual 
profits will be nearly $1,500,000. You can't afford to stay 
out." 

Supposing the facts to be as stated, what economic law 
was overlooked in drawing conclusions? 

2. "Labor once spent has no influence on the future value 
of any article." 

(a) Show that this is true as applied to the wooden 
chair which was used in working out our principle. 

(b) Does the above statement, admitting it to be true, 
invalidate our principle? 

3. At a certain time the price of whiskey in this coun- 
try was about fifty cents, the cost of producing it. The United 
States government thereupon levied on each gallon produced 
a tax of one dollar. What naturally happened to the price 
of whiskey? Why? 



286 PRINCIPLES OF ECONOMICS 

4. "Let us suppose that five or six concerns are supply- 
ing the building brick used in a certain district, and that by 
a new method of manufacture they manage to double their 
output for the former expenses of labor. What will happen 
as regards the price of brick? From our knowledge of what 
competition usually does, we are apt to say : the price of brick 
will fall 50 per cent. This may be the final result, but not 
necessarily so. * * * Manufacturers in normal times will 
increase their production of brick. * * * Xo take off the 
extra supply of brick they must find a wider circle of demand. 
* * * * j^- may, however, happen — not in the case of brick 
probably, but in large articles of limited consumption — that 
there is no such circle of demand at lower levels; then what 
will happen is that the manufacturers will cut down their out- 
put to the same quantity of brick as before, and maintain the 
former high price. * * * It is contrary to all experience to think 
that employers will voluntarily raise wages or pay higher inter- 
est — because costs have decreased. They only do so under com- 
pulsion of fear that their rivals will cut the feet from under 
them. Where competition is active it will often seem as though 
reduction of costs were almost immediately followed by fall in 
prices of products, but, in the last resort — and that is what con- 
cerns us in seeking for a universal law of value — 'the new prices 
are determined by the loiver and wider levels of want which 
are ready to take up increased supply of the mrajority of ordi- 
nary commodities." 

The above quotation is taken from the writings of an able 
economist. It has been modified at a few points to eliminate 
ambiguities. I think, however, that it does not misrepresent 
his views. In any case, it brings out a way of looking at the 
matter which the student should be familiar with. 

(a) State clearly what is the precise point which the au- 
thor seems to be trying to make. 

(b) Show that it is unsound. 

5. A certain residence in Ann Arbor is taxed each year, let 
us say, $42, of which sum $12 is properly chargeable to the 
land while the remaining $30 is chargeable to the house. Un- 
der the operation of the two principles of normal price which 
we have now had, the $30 will really be paid by the tenant, 



NORMAL PRICE DETERMINATION 387 

being shifted from the landlord to him, while the $12 will not 
be shifted and so, as far as the future is concerned, will re- 
main on the landlord. 

Explain how it is that things come out this way. 

Section C. Normal Price of Increasing-Cost Goods 

Fixed-supply goods, we have found, have their prices de- 
termined by demand forces only. Constant-cost goods, on 
the other hand, have their prices determined by supply forces 
only. But in the case of increasing-cost goods with which 
we now deal, forces from both sides participate. This grows 
out of the fact that the supply schedule is of the sort called 
typical in our first account of these schedules. Since, by defi- 
nition, the cost of these products increases as the output in- 
creases, their supply schedule will show a change in supply 
for every change in the supply price. But general demand 
schedules, as explained in Chapter XIV, are practically al- 
ways of the typical sort, showing change in the volume of de- 
mand with every change in price. Hence our present case 
is one wherein both schedules are of the regular type. In 
consequence, any price which does not equalize demand and 
supply sets up a reaction tending to displace that price on 
both the demand side and the supply side ; and these reactions 
influence the determination of the point where price finally 
rests, whether they come from the side of demand or that of 
supply. Normal price, then, for increasing cost goods is de- 
termined by both demand and supply forces. 

Perhaps the best way to confirm this reasoning is to show 
by illustration (i) that every variation in either the demand 
schedule or the supply schedule would cause a change in price, 
and (2) that the determination of the new price would have 
been influenced, not by the changing element only, but also by 
the one which remained constant. The first point may be seen 
by a moment's study of the accompanying table, which gives 
three different schedules of the typical sort on each side. 



288 PRINCIPLES OP BCONOMICS 

Whichever ones we combine at the outset (not including 
T)'" or S'O if we keep the supply schedule constant and unite 
with it a different one of the demand schedules, a new price 
necessarily emerges. A precisely similar result is reached if 
any one of the demand schedules is kept constant and a dif- 
ferent supply schedule combined with it. 



Demand, 000,000 ( 


3Z 


Price 


Supply, 


000,000 oz 


f 








cents , 




A . . .... 


, 


Sch.D'^' 


Sch.D^' 


Sch.D 


' Sch.D 


Sch.S Sch.S' 


Sch.S" 


Sch.S"'' 


230 


190 


230 


210 


60 


310 


330 


290 


290 


240 


200 


240 


220 


59 


300 


320 


280 


280 


250 


210 


250 


230 


58 


290 


310 


270 


270 


260 


220 


260 


240 


57 


280 


300 


260 


260 


260 


230 


270 


250 


56 


270 


290 


250 


260 


260 


240 


280 


260 


55 


260 


280 


240 


260 


260 


250 


290 


270 


54 


250 


270 


230 


260 


260 


260 


300 


280 


53 


240 


260 


220 


260 


270 


270 


310 


290 


52 


230 


250 


210 


250 


280 


280 


320 


300 


51 


220 


240 


200 


240 


290 


290 


330 


310 


SO 


210 


230 


190 


230 



The second point is not so easily seen, but is no less cer- 
tain. When a new price is fixed by the use of a new demand 
(or supply) schedule, that price after all is not made what it is 
simply by this new demand (or supply) schedule: it is also 
influenced by the schedule which was kept constant. To il- 
lustrate, let us start with two combinations both of which 
give a price of 55 cents, namely, demand schedule D with 
supply schedule S, and the same demand schedule with sup- 
ply schedule S''', a schedule which shows supply unchang- 
ing from 53 cents to 57. Let us now substitute demand sched- 
ule D' in the two combinations successively and note the 
different results. The first experiment, putting D' with S, 
causes price to advance one cent, from 55 to 56. The second 



NORMAL PRICE DETERMINATION 289 

experiment, putting D' with S'^' makes price advance two 
cents, from 55 to 57. The obvious reason is that in the latter 
case unchanging supply left to demand alone the equalizing of 
demand and supply and so price had to advance two full 
steps; while, in the former case, increasing supply made pos- 
sible the equalizing of demand and supply one cent earlier, 
and so stopped the rise of price at one step. 

We have seen that the normal price of increasing-cost 
goods must tend to be one which is influenced by the forces 
of both demand and supply and so by all four of those mo- 
ments which fix the limits of price variation, namely, the mar- 
ginal and first extra-marginal demand prices and the mar- 
ginal and first extra-marginal supply prices. But in chapters 
XVI and XVII we learned that the demand prices are ex- 
pressions of the significance or utilities of the several amounts 
of the product in question, while the supply prices are the dif- 
ferent marginal costs of production. Hence in the above state- 
ment we may substitute for the phrases "demand prices" and 
"supply prices" the words "significance" and "cost." In short, 
the prices of increasing-cost goods are determined by both 
significance or utility and cost. More precisely the price of 
an increasing-cost good must not go above that price which 
expresses its marginal significance nor up to one which equals 
its first extra-marginal cost, and must not go below its mar- 
ginal cost nor down to a price which expresses its first extra- 
marginal significance or utility. 

If we assume for the sake of convenience that both the 
demand and supply schedules are perfectly typical and reg- 
ular, it follows that the two upper limits would coincide, and 
the same would be true of the two lower. It would then leave 
our formula still adequate if we were to omit the limit fixed 
by extra-marginal significance or cost and say : "The price of 
an increasing cost product must be one which approximately 
expresses its marginal significance or utility and equals its 
marginal cost." 



290 PRINCIPLES OF ECONOMICS 

Before finally accepting this formula, however, it seems 
desirable to make some comments in the nature of cautions. 
First, in order to anticipate an objectionable interpretation 
which some have made, it is perhaps best to insert the word 
"normal" before marginal cost. The marginal cost is the 
greatest cost at which production is being carried on, and 
this, taken literally, would mean the cost to producers who 
are quite behind the times in methods and facilities and are 
perhaps losing money but have no other alternative than go- 
ing on until they become completely bankrupt. But such per- 
sons are not marginal producers in any proper sense. They 
are wholly abnormal elements, having little or no significance 
in the case. Since by hypothesis they do not quit production 
when it becomes unprofitable, their cost is not a determining 
factor in respect to price. The cost which does determine 
price is the normal marginal cost, or the cost to normal mar- 
ginal producers. 

Another point calling for a moment's attention is the fol- 
lowing: If either or both of the schedules considered are 
discontinuous, price will not necessarily coincide exactly with 
either marginal significance or marginal cost. But it will be 
in so far fixed by both of these that, on the one hand, it must 
not go above the marginal significance nor down to the first 
extra-marginal significance ; while, on the other hand, it must 
not go below the marginal cost nor up to the first extra-mar- 
ginal cost. 

Finally, it is of course always possible to argue that, in 
making up a formula, either one of the determinants might 
be chosen and the other one omitted, on the ground that eith- 
er implies the other. But if we afifirm the relation of price to 
either factor, making no mention of the other, there is dan- 
ger that we shall be understood to mean that the one we do 
mention is alone responsible for the price, to the entire ex- 
clusion of the other. So, in the opinion of the writer, it is 
unsafe to carry the ellipsis further than we do in the formula 
now to be stated. 



NORMAL PRICE DETERMINATION 



291 



Principle. The normal price of increasing cost goods, 
the continued production of which is demanded, tends to be 
a price zvhich both expresses the marginal significance of the 
output and equals its normal marginal cost. 

IlvLUSTRATlVE PrOBIvEMS 

1. Suppose that the production schedule of silver reads 
as follows: at a marginal cost of 55 cents, 170 millions ounces 
can be furnished; at a marginal cost of 56 cents, 175 millions 
ounces ; at 57 cents, 180 millions ; at 58 cents, 185 miUions ; at 
59 cents, 190 millions ; at 60 cents, 195 millions ; at 61 cents, 
200 millions; at 62 cents, 205 millions; at 63 cents, 210 mil- 
lions ; etc. Suppose, secondly, that the demand schedule is as 
follows: 160 millions ounces wanted, if price is 65 cents; 165 
milHons, if price is 64 cents; 170 millions, at 63 cents; 175 
millions, at 62 cents; 180 millions, at 61 cents; 185 millions, 
at 60 cents ; 190 millions, at 59 cents ; 195 millions, at 58 
cents ; 200 millions, at 57 cents ; etc. 

(a) Make out a table giving the ultimate demand and 
supply schedules. 

(b) What must price tend to be? Prove. 

(c) What will it tend to be if demand moves up two 
steps, becoming: 170 millions wanted if price is 65 cents; 175 
millions if price is 64 cents ; and so on. Prove. 

(d) What determines price in these two cases? 

2. "At the present time (1896) silver is being produced 
at a marginal cost of approximately 65 cents per ounce. But 
the price of silver is in the long run determined by its mar- 
ginal cost. Hence it is ridiculous to expect that the adoption 
of free coinage by the United States will raise the price of sil- 
ver, as measured in gold, to $1.29 per ounce, or any other 
figure above 65 cents." 

Admitting that the normal price of silver must in the 
long run coincide with marginal cost, still the above conclusion 
is unsound. Explain. 

3. Suppose the production schedule in Problem i to be 
changed so as to read as follows : at a marginal cost of 55 
cents, 175 millions ounces can be furnished; between 55 cents 



292 PRINCIPLES OF ECONOMICS 

and 59 cents no change is possible ; at a marginal cost of 59 
cents, 500 millions ounces can be furnished; at 60 cents, 525 
miUions ounces ; and so on. 

(a) What would price tend to be when the demand 
schedule was the same in Problem i (a) ? Prove. 

(b) What would price tend to be if the demand schedule 
were moved up as in Problem i (c) ? Prove. 

(c) What would price tend to be if the demand sched- 
ule were moved up two more steps so as to begin : 180 mil. 
oz, wanted at 65c.? Prove. 

(d) What is the point to be made? 

4. The author of a recent text-book in Economics ex- 
presses himself on the relation of cost to price in this vein: 
In the case of reproducible goods, "cost of production seems 
of commanding importance." "In fact, however, marginal 
efficiency (utility) is the real determinant of price," "cost of 
production adjusts itself to this." "There is an abundance of 
silver below the surface that is not mined because it will not 
pay; if the marginal efficiency or value of silver should rise, 
these more expensive grades would at once be marketed and 
the new marginal cost of production would adjust itself to 
the price." 

(a) Construct a sentence running parallel to the last one 
quoted, but exactly reversing the roles of marginal utility and 
marginal cost, whereby it would seem to be proved that mar- 
ginal cost really determines price while marginal utility merely 
adjusts itself to price. The sentence should start out some- 
thing like this : "Generally speaking, it would seem as if mar- 
ginal utility chiefly regulated price. In fact, however, mar- 
ginal cost is the real determinant; marginal utility adjusts it- 
self to this. Below the present demand for silver there are 
numerous layers of demand which are now merely potential 
because the corresponding utilities are below the present mar- 
ket price ; if, now, the marginal cost of producing silver 
should fall, and so the price should fall, these lower layers of 
demand, etc. * * *" 

(b) Show that both the original quotation and our sub- 
stitute are inadequate. 



CHAPTER XIX 

SPECIAL CASES OF NORMAL PRICE 

The general principles governing normal price have been 
brought out in the preceding chapter. But there are some 
cases of a rather unusual character which call for special 
treatment. Some, on account of peculiar complications, are 
not provided for at all in the foregoing principles. Others could 
be fairly covered by a careful interpretation of those princi- 
ples ; but, because of certain peculiarities, further explanation 
is needed to guard against misunderstanding. In still other 
cases, there is reason for attempting a special statement, be- 
cause, although the principles already laid down quite plainly 
apply to them, it is possible for various reasons to go deeper, 
to find some more ultimate statement of the process where- 
by price is determined. 

I. Rare Products 

A very interesting special case is that of produced goods 
which are so limited in possible amount that they behave 
almost like non-producible goods. We think of them as rare 
products. Notable examples are the very rare metals, such 
as radium, iridium, even platinum. We should probably have 
to count in the same class various vegetable products, special 
brands of tea, tobacco, or wines. 

As already indicated, the distinguishing mark of this class 
of goods is the fact that the total possible output is extremely 
restricted as compared with the demands at very high prices. 
In consequence, increases in output through increased ex- 
penditure, though they can be made, are practically negligi- 
ble. Goods of this sort give us a production or supply sched- 
ule which looks something like a regular increasing-cost sched- 
ule. In fact, however, the extreme smallness of increase in 



294 



PRINCIPLES OP ECONOMICS 



output with rise in price differentiates these from the typical 
cases such as we had in silver. The accompanying schedule, 
an imaginary one for a very rare brand of tea, may be taken 





Demand 




Price 


Supply 






000 pounds 




dollars 


000 pounds 




D^' 


D' 


D 


S 


S' 


I 


6 


3 


500 


11.683888 


40 


2 


8 


5 


450 


11.683885 


25 


3 


10 


6 


400 


11.68388 


18 


5 


12 


8 


350 


11.68387 


15 


6 


13 


10 


300 


11.68385 


13 


8 


15 


12 


250 


11.6838 


12 


10 


18 


13 


200 


11.6835 


10 


12 


25 


15 


150 


11.683 


8 


13 


40 


18 


100 


11.682 


6 


15 


60 


25 


50 


11.680 


5 


i8 


100 


40 


24 


11.675 


3 


25 


120 


60 


10 


11.650 


2 


40 


160 


100 


5 


11.600 


I 


60 


180 


120 


4. 


11.500 




100 


200 


160 


3- 


11-350 




120 


500 


180 


2.50 


1 1. 100 




160 


700 


200 


2. 


10.800 




180 


1,500 


500 


175 


10.500 




200 


3,000 


700 


1.50 


9,900 




500 


10,000 


1,500 


1-25 


9- 




700 


15,000 


3,000 


I. 


77 




1,500 


20,000 


10,000 


•75 


6. 




3,000 


30,000 


15,000 


•50 


4- 





as representative. Every considerable increase in output takes 
place while cost is still quite low, and after that cost has 
passed $25, the additions are all in pounds and even fractions 



SPECIAL CASES OF NORMAL PRICE 295 

of a pound. If this supply schedule be combined with the 
demand schedule marked D, a price of $250 per pound re- 
sults, and this price is really determined in just the same way 
it would be if the possible output for each year were abso- 
lutely fixed at 11,000 pounds, — by the marginal significance. 
The fact that the output can be increased beyond 11,000 
pounds, and the further fact that in the end the price actually 
coincides with the marginal cost of production, have really 
nothing to do with fixing the price at $250. Marginal signifi- 
cance alone is effective. 

This contention is most plainly established by noting the 
effect of raising or lowering the demand schedule and see- 
ing how the results differ from what they would be if we 
had a typical case of increasing-cost goods. Thus, when de- 
mand schedule D', representing demand as having advanced 
two steps all along the line, is combined with the supply sched- 
ule, price also advances two steps, from $250 to $350. So de- 
mand schedule D''', which represents one resulting from a de- 
cline of two steps in demand, causes the price also to drop 
two steps, from $250 to $150. If now our supply schedule 
had been a typical one wherein supply appreciably increased 
as the marginal expenditure increased, — represented in sched- 
ule S', the result would have been quite different. Our orig- 
inal demand schedule D combined with this new supply sched- 
ule would have given us, as before, a price of $250. But the 
change to D' would have caused an advance in price, not of 
two steps, but only of one, from $250 to $300. So, combining 
jy with the new supply schedule would have caused a drop 
in price, not of two steps, but only one, from $250 to $200. 

The reason is plain. In the latter case, the substantial in- 
crease in output as price rose under schedule D' brought 
supply and demand together at an earlier price ; while the sub- 
stantial falling off in output, as price fell under schedule T/' 
brought supply and demand to equality at the earlier point. 
With the original supply schedule, both of these conditions 
were lacking. The increase as price rose was negligible, the 



296 PRINCIPLES OF ECONOMICS 

decrease as price fell was negligible. The new prices, there- 
fore, were fixed without respect to supply or cost. We have 
in effect here a fixed-supply or fixed-output commodity, the 
price of which is determined by marginal significance alone. 

2. Joint-Cost Products 

In studying not a few producible goods, we strike a com- 
plication due to the fact that several different commodities 
emerge from the same productive process. Thus, the dairy- 
man simultaneously and by undivided and undistinguished 
productive efforts brings into existence milk, butter, cheese, 
beef, and hides. The refining of petroleum yields not only 
common illuminating oil^ kerosene, but also vaseline, gaso- 
lene, and naphtha. Again, the coal tar resulting from the dis- 
tillation of coal for the making of gas gives us a whole line of 
by-products, including various drugs, perfumes, and a large 
number of dyes. Now, in cases like these it is difficult, if not 
impossible, to isolate the share in the cost of production 
which is properly chargeable to each of the several products. 
This being true, we surely cannot apply to these goods, with- 
out qualification, the principle laid down for other producible 
goods. 

The special theory needed here was set forth by Mill. It 
is that the price of each of the individual products must be 
such as to equalize supply and demand for that product ; 
while the money value of the whole group of products must 
equal their cost of production. In consistency with the mod- 
ern analysis which goes behind demand to significance or 
utility, we should change the first part of this formula to read 
"the price of each of the individual products must tend to be 
that price which expresses the marginal significance of the 
quantity of that particular product which is put upon the mar- 
ket." The second part of the formula can remain unchanged. 

The argument in support of this principle is as follows. 
First, the price of each member of the group of products must 



SPECIAL CASES OF NORMAL PRICE 297 

be such as to express its marginal significance, because, un- 
der the conditions given, the quantity of each of the products 
is virtually fixed, and hence it comes under the laws of fixed- 
supply goods. This, of course, does not mean that the sup- 
ply of each commodity is literally unchanging; but that its 
changes do not take place in response to conditions • which 
affect that commodity itself only, but rather in response to 
conditions which affect all the commodities of the group. 
When, therefore, the price of any one of them is in process 
of determination, the supply of that one is virtually fixed; and 
hence the principle governing its price is the one which gov- 
erns the price of fixed-supply goods. But the principle in 
question makes the price of these goods depend upon mar- 
ginal significance ; and so, marginal significance governs the 
case now before us. 

It is no less certain that the prices of all the members of 
the group must be such that the sum total of their money 
values will equal their joint cost of production. This result 
is bound to be brought about through processes already thor- 
oughly familiar. If at any point the sum total of the group 
prices should rise above this total cost of the group products, 
capital will move into the industry, supply all along the line 
will increase, marginal significance will fall, and so prices 
will fall. Conversely, if the total costs are not covered by 
the total values, capital will withdraw from the industry, the 
supply of the several commodities will fall off, their marginal 
significance will rise, and so prices will rise. Doubtless this 
readjustment would be much more complicated and hence 
much slower than in the case of isolated individual products, 
but in the long run it would inevitably come about. 

Principle. The price of each member of a group of joint- 
cost products tends to he that price zvhich expresses the mar- 
ginal significance or utility of the quantity of that particular 
product zvhich is put upon the market, provided that the sum 
of the money values of all products of the group tends to 
equal their joint cost of production. 



298 PRINCIPLES OP ECONOMICS 

Ii^ivUSTRATivi: Problems 

1. Enumerate some products of a Michigan farm which 
might be thought of as by-products. 

2. Discuss the question as to whether the transportation 
between Detroit and Jackson of products of quite different 
types, for example, coal and dry goods, truly gives rise to a 
case of joint-cost products. 

3. "The recent fall in the price of cotton is largely due 
to the improved manufacture and (increased) uses of cot- 
ton-seed oil." Marshall's Economics of Industry, page 225. 

Explain why these facts should tend to cause a fall in the 
price of cotton. 

3. Diminishing-Cost Goods 

If the wooden chair, the output schedule of which was 
presented in Chapter XVIII is taken in the earlier stages of 
this schedule, it belongs in the class of diminishing-cost 
goods, — the more output producers try to furnish, the smaller 
is the cost per unit. This case we sometimes treat as a third 
sub-division of variable-supply goods. The general princi- 
ple for variable-supply goods that price tends to equal cost, if 
properly interpreted, is really adequate here, and proper in- 
terpretation only requires us to remember that the cost of 
production meant in our principle is the cost which is repre- 
sentative at the very time mentioned, not at an earlier or a 
later date. Nevertheless, as this case is one of unusual prac- 
tical importance, it seems to deserve special comment. 

The theory is comparatively simple. So long as the de- 
mand for commodities of the type considered is still relatively 
small, persons producing them are obliged to employ expen- 
sive methods of production ; hence cost and, so, price is high. 
Presently, demand shows a large increase, and in consequence 
producers are able to realize the various gains of large-scale 
production, with the result that cost and, so, price is greatly 
diminished. Accordingly, if we wish to look at the period 
which includes these changes as a totality and state the law 



SPBCIAL CASES OF NORMAL PRICE 299 

which governs that period as a totahty, we have to say that 
price tends to equal the lowest of the costs of production. The 
importance of this law is best seen in connection with the 
theory of investment. In the earlier stages of a new indus- 
try, while crude or experimental methods are being employed, 
price is so high that producers who intend to introduce im- 
provements which will greatly reduce cost are wont to an- 
ticipate therefrom enormous profits, and perhaps attempt to 
attract investors by representations to this effect. But in- 
vestors should remember that, just because it is going to be 
possible to reduce cost of production, the price itself is bound 
to fall, and the great profits described by promoters will, in 
all likelihood, fail to be realized. 

The principle may be succinctly stated as follows : 

Principle. The price of diminishing-cost goods tends to 
equal their cost to producers working on the largest scale jus- 
tified by the existing conditions of demand, — monopoly being 
excluded. 

4. Fixed-Supply Income-Bearers 

Another special case is furnished by the fixed-supply in- 
come-bearer, for example, a piece of land rented for business 
purposes. First, with regard to income-bearers in general, 
we remark that, between their prices and their incomes there 
must tend to prevail at all times a fixed ratio approximately 
equal to the current rate of interest. When the rate of in- 
terest on money loans is approximately 5% then, between the 
price of an automobile, let us say, which is to be used for pur- 
poses of hire and the net money income derived from that 
automobile, — due allowance having been made for repairs, 
replacement, labor services, and so on, — the ratio is bound to 
be approximately 100 to 5 or 20 to i. 

Now, the establishment of this ratio may conceivably be 
brought about in either of two ways: (i) the price of the au- 
tomobile having been fixed, the income may move up and 



300 PRINCIPLES OP ECONOMICS 

down till it settles at a figure just 1/20 of the price of the au- 
tomobile, or (2) the income having been fixed, the price of 
the automobile may move up and down till it settles at a fig- 
ure just 20 times as great as the income. Which will it be? 
This depends surely on which of the two things, the income or 
the price of the auto, is free to move, and so able to put itself 
in the required relation to the other. With a commodity like 
the automobile, the one which must do this is surely the net 
income. As we have just remarked, the price is fixed by cost 
of production, and therefore is not able to move at all. The 
income, however, moves with perfect freedom. If the net in- 
comes derived from renting automobiles are too large con- 
sidering the price of machines, then competition will increase, 
and in consequence rentals and incomes will decline. If in- 
comes are too small, competition will lessen, whereupon rent- 
als and incomes will increase. Accordingly, we may say of 
producible income-bearers, that their price is first fixed and 
to this price the net income is adjusted.* 

Passing, now, to non-producible income-bearers such as 
land, we find ourselves facing a very different problem. No 
element of cost is here in operation. Utility or significance 
only can afifect price ; and the particular significance which ef- 
fects it is obviously that given ofif by the land for a certain 
definite time. In short, the first thing to be fixed is, not the 
price of the land as a whole, but the price of a year's use of 
the land, its income ; which income, having been fixed, de- 
termines in some way the price of the land itself. 

Here again, as with producible income-bearers, the rela- 
tion between the price of any income-bearer and its income is 



* The student must remember, however, that the price of con- 
stant-cost goods is not ahvays governed by cost. A necessary condi- 
tion was expressed in the phrase, "the continued production of which 
is demanded," which appears in the formula on page 285. Produci- 
ble income-bearers at times pass into the status of non-producible 
ones. 



SPECIAL CASES OF NORMAL PRICE 301 

£xed in advance* by the existing ratio between capital in 
general and the income therefrom. When 5 per cent, is the 
prevailing rate of interest, we can be pretty sure that the net 
yearly income of a piece of ground which commands a price 
of $1,000 must be about $50. 

In this respect, then, the piece of ground and the automo- 
bile are alike. But, in the matter of the causation, as we said, 
the cases are entirely different. The income of the machine 
adjusts itself to its price or cost; the price of the land ad- 
justs itself to its income. We cannot say : the land is worth 
$1,000, hence its net income must be $50. Rather, we must 
say: the net income of the land is $50, hence its value must 
be about $1,000. To use another illustration, suppose a cer- 
tain building site regularly yields a net income of $100, and 
that the current rate of interest on long-time loans is about 
5 per cent. Then, the price of the site will tend to be as many 
dollars as .05 is contained in 100, or $2,000. The usual pro- 
cedure, when 5 per cent, is the rate, is to multiply the income 
by 20, which gives the same result as dividing it by .05. 

If, now, we put into formal shape the point here elaborat- 
ed, we have the following 

Principle. The price of an income-hearing property not 
capable of duplication tends to equal the sum of money which, 
lent at the current rate of interest, would yield a yearly in- 
come equal to the net yearly income of the said property. 



* This is not to say that the income-bearer in question has no 
weight in determining the ratio between capital in general and the 
income therefrom. Doubtless every transaction involving an exchange 
of present wealth for the right to a series of future incomes helps 
somewhat in fixing the rates at which all such exchanges take place. 
But as we have already seen, the price-making forces come to a head, 
so to speak, in a particular class of transactions, — those which are mar- 
ginal, those in which marginal significance or marginal cost or both 
are determined. Accordingly, we can safely treat almost any partic- 
ular transaction of the kind here engaging us, as one to which is be- 
ing applied a ratio of exchange already determined elsewhere. 



302 PRINCIPLES OF ECONOMICS 

ILI.USTRATIVE PrOBIvEMS 

1. If a certain mining stock pretty generally yields a net 
income each year of $54 per share, what would its price tend 
to be, supposing that the usual rate of return expected in such 
lines of industry is about 7 per cent.? Prove. 

2. If the dividend of the above stock fell to $37, what 
would you expect the price of the stock to become? 

3. Suppose you are considering the purchase of a $100 
government bond, untaxed and paying 2 per cent, interest. 
What price could you reasonably pay, if the rate commonly 
obtained on securities of this grade was 1.9 per cent.? Prove. 

4. Here is a piece of farm land which regularly yields a 
net income of $1,700. What would its price tend to be when 
the rate of interest in such lines was about 5.5 per cent? 

5. Here is a site in a large city which yields a ground 
rent of $51,000 a year. Suppose that the Henry George ideas 
came to prevail in said city, so that the tax on the site named 
is fixed at 93 per cent of its rent. 

(a) What would the price of the site tend to be w^ien 
the rate of interest was about 5 per cent? 

(b) What would it be if the rate of taxation were raised 
to 100 per cent., the rate of interest remaining 5 per cent. ? 

6. Supposing that there were no interfering causes, what 
would you expect the price of a government bond bearing 2 
per cent, interest to do in times when the rate of interest has 
been exceptionally high for many months? 

7. A certain building site regularly yields a net income 
of $300 a year. This fact would cause it to have what mar- 
ket value when the rate of interest was 8 per cent.? 6 per 
cent. ? 5 per cent. ? 

8. A certain automobile which is hired out, regularly 
yields its owner a clear income over all expenses of about 
$300 per year. With interest at 6 per cent., this fact would 
cause the car to have what market value? Is this a rea- 
sonable problem? 

9. An automobile costs $1,200 and lasts only three years. 
With interest at 6 per cent, and with 6 per cent, added for 
the trouble and risk of running an automobile livery, what 



SPBCIAL CASES OP NORMAL PRICE 



303 



must an automobile earn during a year to make the business 

pay? 

10. A certain building site is worth $22,000. With in- 
terest at 6 per cent., what surplus over other expenses must 
any business located on the given site pay in order to make 
the use of the site for that purpose profitable? Interpret it 
so as to make it an illegitimate one. 

5. Price Under Monopoly 

As we have emphasized repeatedly, our discussions of 
price determination assume perfect freedom of competition. 
The consistent distribution of topics would therefore seem to 
require that the discussion of monopoly should appear sepa- 
rate from, and supplementary to, the treatment of price in 
general. We shall not, however, be able to undertake an ade- 
quate treatment of the topic in any connection, so that it seems 
best to touch upon some of its most significant features here. 
Moreover, this procedure is in a sense justified by the fact 
that price-determination under monopoly is not a process dis- 
tinctly different from those already described, but merely a 
variant from them. Monopoly, as it were, injects into the sit- 
uation a new condition under which the principles already 
noted as operative work out the result. 

The first point to be made is that, in respect to its more 
immediate determination of price, we have under monopoly 
merely a special case of fixed-supply goods. The supply of 
the monopolized good is a fixed one; but this fixedness is not 
of natural origin, is not due to any absolute limit nor to the 
limit of our capacity to produce. Rather, the monopolist con- 
sciously, arbitrarily limits the amount produced, or, at any 
rate, the amount put on the market. It follows that, imme- 
diately speaking, the law governing monopolist price is the 
same as that given for fixed-supply goods. The normal price 
of goods sold under the condition of monopoly must be one 
which expresses the marginal significance or utility of the out- 
put. The only qualification needed is one which recognizes 



304 PRINCIPLES OF ECONOMICS 

the artificial nature of the Hmit set. We might then restate 
the formula as follows : The normal price of monopoly goods 
tends to he one which expresses the marginal significance of 
the supply as fixed by the free choice of the monopolist. 

The second point to be noted gives us a more fundamen- 
tal governing principle, — a principle which tries to define the 
normal price of monopolized goods, the price which, in view 
of all the circumstances, including "the free choice of the mo- 
nopolist," tends to be established. The use of the word "nor- 
mal" here may sound strange; for it is probable that most 
people think of monopoly and the monopolist's free choice as 
doing away with all normality of price, — as fixing price in a 
purely arbitrary way. This, however, is going much too far. 
Monopoly prices, though less submissive to natural laws than 
competitive prices, are not, after all, entirely free from such 
laws. The monopolist is coerced by conditions into fixing his 
prices, not according to his own caprice, but in conformity 
with certain broad principles over which he has no control. 

In the first place, if a monopolist puts his prices too high, 
he will be disappointed in finding his gains smaller than they 
would be if he had set his price lower. Thus, suppose that pe- 
troleum is a monopolized product, and that a section of its de- 
mand schedule is as follows: 1,900 million gallons wanted if 
price is 9 cents ; 2,500 millions if price is 8 cents ; 3,000 mil- 
lions, if 7 cents ; 4,000 millions, if 6 cents. Suppose, further, 
that the total cost per gallon is 4 cents, so that there is a clear 
profit of 5 cents per gallon if the selling price is 9 cents ; of 
4 cents per gallon, if price is 8 cents ; and so on. If, under 
these circumstances, the monopolist fixes the price at 9 cents, 
he will clear $95,000,000, whereas at 8 cents he would have 
cleared $100,000,000. What he gains through larger profit 
on each unit of product he will more than lose by diminishing 
the total number of units sold. 

On the other hand, it would be foolish for the monopolist 
to go to the opposite extreme in carrying out a policy of low- 
ering price in order to increase demand. Thus, if he puts 



SPECIAL CASES OF NORMAL PRICE 



305 



the price down to 7 cents, he will indeed cause demand to in- 
crease from 1,900 millions to 3,000 millions; but the lowering 
of profit on each unit will more than offset this gain in amount 
sold. His net profit will drop to $90,000,000. In short, the 
self-interest of the monopolist will dictate that he fix on the 
price which insures that the product of the net profit per unit 
output into total output is the highest possible ; and this gives 
us the general principle determining normal price under con- 
ditions of strict monopoly. 

Principle. Broadly speaking, the normal price of any 
monopolized commodity tends to he that price which will se- 
cure the largest net return to the monopolist. 

A cursory examination of the preceding analysis shows 
plainly that the cause which hindered the monopolist from 
pushing price upward indefinitely was the fact that as price 
rose demand fell off, — in other words, demand was elastic, 
varying inversely as price. If demand had diminished more 
rapidly with increase in price, the price actually established 
would have been still nearer cost of production. If demand 
had changed less rapidly with increase in price, price would 
have been put still farther above cost of production. Hence the 
following 

Corollary, The tendency of monopoly price to rise above 
the competitive normal varies inversely as the elasticity of the 
demand for the monopolised commodity. 

It obviously follows from this corollary that every cause 
which increases the elasticity of the demand for a given com- 
modity diminishes the tendency of price in said case to sepa- 
rate from the competitive normal. Thus, the appearance on 
the market of a commodity which can be used as a substitute 
for some monopolized one diminishes our dependence on the 
latter and so makes its demand schedule more elastic. 

The preceding discussion has brought out the general 
principle governing normal price under monopoly. But it is 



3o6 PRINCIPLBS OF ECONOMICS 

possible to be a little more specific regarding one particular 
type of monopoly which has much prominence in our day. 
This is known as the capitalistic monopoly, — one which owes 
its origin to the control by the monopolist of an exceptional 
volume of capital. Such a condition enables a man or group 
of men to attain the position of monopolist, to gain and main- 
tain exclusive control of output, largely because it enables 
them to produce more cheaply than rivals and hence drive 
them out of business. But it is plain that, to succeed, mo- 
nopolies of this sort must keep prices fairly low, — somewhere 
in the neighborhood of cost to outsiders; since otherwise com- 
petitors will be continually starting up, and will have to be 
bought out at considerable cost or driven out by destructive 
commercial wars. Formulating this point, we have the fol- 
lowing 

Principle. The normal price of goods produced by capi- 
talistic monopolists tends to approximate a figure not much 
above cost of production to outsiders. 

IlIvUSTrativi; Probi^i^ms 

1. Suppose the demand schedule for Milton's autographs 
is as follows: i wanted at $200; 2 at $175; 4 at $150; 5 at 
$140; 8 at $125; 9 at $119; 12 at $100; 13 at $90; 15 at $75; 
and 20 at $50. 

(a) If there came on the market 9 autographs, what 
price would they tend to have under free competition? 

(b) What price if all were owned by one man? 

(c) Answer the same questions, supposing the number 
of autographs to be 15. 

(d) Answer the same questions, supposing the number 
to be 20. 

2. When the United States Steel Company was fully or- 
ganized, many independent producers desired the Trust to 
join with them in raising the prices of steel products. The au- 
thorities of the Trust, however, refused, thinking it expe- 
dient to maintain the old level. What do you suppose was the 
reason ? 



SPECIAL CASES OF NORMAL PRICE 307 

M1SCE1.LANEOUS Proble^ms in Price; 

1. There come on the market eleven specimens of a 
certain rare object to be disposed of at the best price attain- 
able. If the demand is as follows: i wanted at $65; 2 more 
at $60 ; 4 more at $50 ; 5 more at $45 ; 6 more at $40 ;etc., 
what price will tend to be reached? Prove. 

2. In the last problem, suppose a tax of $5 to be levied 
on each specimen sold. 

(a) What effect on price would be produced? 

(b) Who would bear the tax in the end? 

3. In stating the principle that the prices of goods tend 
to equal their money cost of production, some writers pre- 
fer to say "cost of reproduction." 

(a) Why do you suppose they have this preference? 

(b) Show that, on the assumption implied in the very 
idea of normal price, the change from "cost of production" to 
■"cost of reproduction" is at least unnecessary. 

4. "If the state should inaugurate the policy of levying 
on the livery business a lo-per-cent income tax, the value of 
all plants devoted to this business would necessarily fall oft 
10 per cent." Criticise. 

5. "Every owner of a railroad, of a patent, of a book, 
or of a (monopoly) property of any kind, finds that he makes 
more money by putting prices down to figures that are rea- 
sonable, that is, to figures which correspond to the values to 
the buyers of the things sold, than by keeping them up beyond 
those figures." — Stickney. 

(a) Show that the words "which correspond to the val- 
ues to the buyers of the things sold," are useless as a defini- 
tion of "reasonable" prices. (Try to think of some object 
which has a price greater than that one which would express 
the value of the object to buyers.) 

(b) In the case of producible goods, what price is com- 
monly considered a reasonable one? 

(c) When "reasonable" is understood this way, is it 
probable that the first half of Sticlcney's statement is true? 

(d) Point out some cases of monopoly of which the 
statement can be affirmed with a fair degree of accuracy. 



3o8 PRINClPinS OF ECONOMICS 

6. "Analogous arguments, * * * might be made with 
regard to municipal railways, lighting companies, and water 
companies. These are all, for one cause or another, of a 
monopolistic character. The public enjoys no guarantee of 
fair treatment on account of any competition that can affect 
them." Adams' Finance, p. 264. 

What is the doctrine with respect to competitive indus- 
tries which is implied in the last sentence of the quotation? 

7. "When the demand for wheat increases so as to ex- 
ceed the capacity of the best land, the price of wheat rises so 
as to leave an excess or surplus over cost of production, and 
this surplus is driven into the hands of the landowner as rent 
by the natural competition of tenants. But, now, the high 
price of wheat leads to the cultivation of inferior soils, which 
increases the supply of wheat so as to satisfy the demand, and 
thus brings the price of wheat hack to its old place." Criticis'e 
the part in italics. 

8. "Alone and lost in the desert, his last morsel of food 
and his last drop of water gone, he would cheerfully have giv- 
en his gold, his yachts, his palaces, all his wealth, for the mea- 
ger fare of the day laborer. At last the illusions which he 
shared with civilized society were fully dispelled. The un- 
utterable folly of the comparative estimates which men com- 
monly put on things became manifest. At last, on the verge 
of oblivion, he saw things in their true, their real, propor- 
tions." Criticise. 

9. A certain man improves the opportunity offered by a 
growing city of 40,000 inhabitants to develop a messenger 
service business, from which at the end of three years he finds 
himself getting a net return, after allowing himself wages 
for management, of $700. The capital invested, which in- 
cludes a bank balance of $200 which he commonly maintains, 
is only $500; but he has to provide for a pay roll of about 
$200 a month or $2,400 a year. He now tries to sell out the 
business, asking for it $8,750. Assuming that the good will 
of the business is worth $500, and that 8 per cent, is a rea- 
sonable rate of interest and profit, is the price proposed a rea- 
sonable one? Does the size of the pay roll make any differ- 
ence ? Explain. 



SPECIAL CASES OF NORMAL PRICE 309 

10. A railway lawyer is trying to prove before a court 
that a proposed 2 cents per mile passenger rate is unjust to 
his road in that it will not permit paying a reasonable profit, 
say 6 per cent., on the investment. He admits that this rate 
will be realized on the physical equipment of the road, valued 
at $5,000,000 ; but argues that the company has to provide for 
a pay roll of $50,000 every month and ought to earn profits on 
this as well. Now this claim may or may not be reasonable. 
It all turns on whether providing for this pay roll involves, 
etc. Finish the sentence. 

11. "A friend of mine owns in a Chicago suburb a house 
and lot which used to rent for $300 a year. Last year real es- 
tate in his neighborhood had a boom, with the result that his 
property increased in value $3,000. In consequence he raised 
the rent to $480." What is the matter with the economic doc- 
trine involved? 



CHAPTER XX 

THE THEORY OF FINAL PRICE DETERMINATION 

That our previous teaching with respect to the processes 
and laws of price-determination is more or less provisional 
has already been affirmed or implied in various connections. 
It is now incumbent on us to explain why this is true and to 
supply something more final. 

The principal inadequacy in our previous treatment con- 
nects itself with the prices of producible goods, and, more es- 
pecially, with the doctrines which relate the prices of such 
goods to their cost of production. Throughout our discus- 
sion of those doctrines, it was assumed without comment that 
those constituents of cost for which the entrepreneur has to 
make a money outlay have prices which he finds determined 
once for all. Starting out to manufacture some commodity, 
he learns that he must pay so much for raw materials, so 
much for tools and machinery, so much for labor, and so 
much for the use of capital. In consequence of these facts 
and in consideration of various sacrifices required from the 
entrepreneur himself, the product which he puts on the mar- 
ket must necessarily have a certain price. 

Now, our assumption that the prices of cost-goods are 
fixed, determinate quantities, is for many purposes sufficiently 
near the truth. But, if our concern lies with the really ulti- 
mate economic facts, the assumption is distinctly false. In 
the first place, some cost goods are themselves products; 
hence, their prices cannot be fixed, but rather must be in 
process of determination under the same principles which are 
determining the prices of final or consumers' products. Since 
lumber is a product of standing timber, labor, etc., its price 



PINAL PRICE DETERMINATION 



311 



must undergo a fixing process not essentially different from 
that of furniture which is a product of lumber, labor, etc. 

At first thought it might seem as if this difficult) could be 
met by differentiating between produced cost-goods and what 
we will call primary cost-goods, — primary cost-goods or fac- 
tors being those which cannot be resolved into anything ante- 
cedent to themselves, for example, the soil, ores in the earth, 
water power, and labor. On this plan, the prices of the pri- 
mary cost-goods would be conceived as antecedently fixed ; and, 
being thus fixed, they determine the prices of intermediate 
products or produced cost-goods ; when, finally, the prices of 
these latter determine the prices of consumers' products. 

But we are really no better off than before. We have, in- 
deed, gotten rid of the absurdity of representing the prices of 
produced cost-goods as determinate; but we still assume that 
the prices of primary cost-goods are determinate, an assump- 
tion which is little less absurd than the former. Iron ore 
stored up in the earth, a favorable site for business, the soil 
itself, a day's labor, none of these has a specific price attach- 
ing to it from eternity. The price of every one of them, as 
we all know, is frequently altered. We must not infer from 
this that the principles heretofore laid down, on the assump- 
tion of fixed-price primary cost-goods, are theoretically in- 
valid, or practically of no importance. In their relation to any 
particular product, and, for extended periods in their relation 
to products in general, the prices of cost goods are in fact de- 
terminate. In dealing with most practical problems, the as- 
sumption of such determinateness is entirely legitimate. Nev- 
ertheless, the prices of these primary cost-goods, when consid- 
ered in any ultimate sense, are not things determinate, but on 
the contrary, things which frequently show change. And this 
circumstance must of necessity have some influence upon the 
prices of goods produced from the primary cost goods. 

We thus find ourselves face to face with certain funda* 
mental problems in respect to value or price which, if we wish 



312 PRINCIPLES OP nCONOMlCS 

to get something like an adequate notion of the whole mat- 
ter, can no longer be neglected. Of these problems, the most 
central one concerns the processes whereby the prices of pri- 
mary cost-goods or factors are determined. Accordingly, our 
next task will be to attempt a solution of this problem. 

Section A. How the Prices of Primary Cost-Goods or 
Factors Are Determined 

In the literature of our subject, this problem has seldom 
been distinguished as sharply as its importance merits, being 
usually confused with the more superficial processes of price- 
determination which have been studied in previous chapters. 
Nevertheless, one may distinguish at least three types of doc- 
trine concerning this problem, as being implicit in price dis- 
cussion. One group of writers teach that the value or price 
of the primary factors is determined solely by their marginal 
utility : the productive capacities and resources of man are 
progressively distributed over the whole field of production, 
from the most important products downward till they are all 
used, and their utility in the marginal use fixes their value. 
A second group find the sole determinant in the cost, — the 
disutility cost — of supplying directly the human elements and 
making available the elements coming from nature, outside of 
man. Psychic cost is the original cost of everything, and de- 
termines what we must pay to secure the forthcoming of sup- 
ply. A third group recognize the presence of both utility and 
cost determinants in the process, advocating what is often 
called an equilibrium theory. 

The doctrine maintained in this text is a form of the 
equilibrium theory. It gives most weight to significance or 
utility, but it insists on recognizing the influence of disutility 
cost in the case of those primary factors which can be sup- 
plied only by processes which involve that element. It may 
be formulated for the sake of definiteness in the following 
statement : 



FINAL PRICE DETERMINATION 313 

Principle Governing the Prices of Primary 
Cost-Goods 

Broadly speaking, the price of any primary cost-good 
tends to be that price which expresses the marginal economic 
significance of that cost-good to society in view of the totality 
of conditions which at the inoment obtain, and zvhich also ex- 
presses the marginal disutility of supplying said cost-good in 
case there is such a disutility. 

In maintaining this proposition, we will begin with the 
second or disutility part as involving fewer difficulties in 
analysis and presentation. 

I. The Prices of Primary Cost-Goods and Disutility 

It is a fact too evident to need argument that the supply- 
ing of those primary cost-goods which are of human origin 
may, anyhow, involve a disutility. Working or waiting or 
taking responsibility can be carried so far as to be distaste- 
ful. Further, it cannot be doubted that at the present time, in 
societies which have attained to any high economic develop- 
ment, the supplying of these services has, with many of the 
persons concerned, gone so far that disutility is now actually 
felt. Much or most of the labor furnished carries with it a 
psychic sacrifice; and the same is true of some part any- 
how of the waiting and responsibility-taking. 

Again, it cannot be doubted that, as respects a portion of 
the supply, the amount of that supply is influenced by the 
disutility involved. Certain persons supply less than they 
would if the disutility of doing this were diminished. We 
will not work as many hours per week, or month, or 
year, as we would if there were no disutility attaching to our 
efforts ; and the same surely is applicable to waiting and re- 
sponsibility-taking. 

But, if the supply of these services is bound to be less — 
appreciably less — because of the disutility involved, it neces- 
sarily follows that the prices of such services will tend to be 



314 PRINCIPLES OF ECONOMICS 

higher on account of this disutility. In this statement, the 
adverb "appreciably" was inserted to exclude one hypothesis 
under which the statement would not hold. If the demands 
for these types of service were so great as compared with 
our capacity to furnish them that their price would be far 
above any disutility at which an appreciable addition to out- 
put could be made, their prices would be fixed by utility or 
significance without respect to disutility, like the tea in our 
rare-goods problem. Under such a hypothesis, if there was 
coincidence between price and marginal disutility, this would 
be due to the fact that the marginal disutility had adjusted 
itself to a price already determined by utility or significance. 
But manifestly this hypothesis is quite outside the limits of 
practical life. We could add materially to the output of all 
these types of service by pushing ourselves harder. In fact, 
we often do so under the special stress of circumstances, as 
has been shown many times during the present war. It is, 
then, quite certain that the disutihties involved in supplying 
these primary factors of production commonly have some in- 
fluence on their prices. 

But, again, it can scarcely be doubted that this relation 
between the disutilities of supplying these primary factors 
and their prices is capable of more precise statement. The 
marginal disutility of each quantity of these factors supplied 
will naturally determine the supply price of that quantity. 
Now, the actual price being stopped from going below the 
marginal supply price, or up to the first extra-marginal sup- 
ply price, will necessarily be stopped from going below a 
price which expresses to the man supplying the factor the 
marginal disutility of doing this or up to a price which ex- 
presses the first extra-marginal disutility of doing it. Hence 
we seem justified in considering the second part of our for- 
mula appearing on page 313 established. The price of any 
primary cost-good tends to be that price which '^expresses 
the marginal disutility of supplying said cost-good in case 
there is such a disutility." 



PINAL PRICE DBTBRMINATION 315 

The above argument in support of the proposition that 
the prices of the primary factors must adjust themselves to 
the disutiHties of supplying those factors, is obviously based 
on the ordinary principles of price-determination. Looked at 
by large, there would seem to be no doubt as to its validity. 
There are one or two objections, however, which perhaps 
should receive a moment's attention. First, it is often ob- 
jected, though not by economists, that, in the supplying of the 
major part of two of these services, waiting and risk-taking, 
no disutility is involved. Much of the capital of the world 
is furnished by persons who could not consume their incomes 
if they tried. Anyhow, they would find the task much more 
difficult than that of saving. In like manner, many entre- 
preneurs are glad to undertake the responsibilities of busi- 
ness, for the sake of the power and prestige which it brings, 
and because they positively enjoy the taking of risks. 

To this objection the answer is easy. In all value prob- 
lems, we are concerned, not with the attitude of the majority 
of the persons involved, but with that of the marginal units. 
If there is any considerable amount of the capital in use 
which would not be forthcoming if the disutility of supply- 
ing it were increased, disutility is bound to play a part in de- 
termining the price of waiting. And surely this is the case. 
Many persons are supplying capital who find the burden 
of doing so almost unbearable. Similar reasoning applies to 
the case of responsibility-taking. There are surely a large 
number of entrepreneurs who are almost ready to give up 
providing this function because its burdens are so great. It 
is their attitude, their readiness to drop into some other field 
of activity if the reward is not sufficient to cover the dis- 
utilities they experience, which really determines that the 
disutility in question must influence the price paid for this 
service. 

Another objection applying especially to labor is that, un- 
der modern conditions, the laborer's freedom of action is too 
limited to make possible the working of the process indicated 



3i6 PRINCIPLES OP ECONOMICS 

above. Doubtless under a simpler order of things the laborer 
would tend to cease furnishing the supply of his services as 
soon as the added utility fell below the marginal disutility of 
his labor. In other words, he would stop his day's work, say 
at ten hours, or nine, or eight, unless an additional hour 
would clearly add enough to product to offset his discom- 
fort. But under modern conditions the length of the day is 
largely a fixity, determined by custom and by the necessities 
of business processes in which great numbers of persons and 
a great volume of capital are working in co-ordination. The 
laborer cannot decide of his own motion to shorten his day 
to nine hours or eight hours ; since he is only a part in a vast 
and complicated mechanism. This shortening of the day can 
only be done concertedly by the common consent of many 
employees and many employers. 

This objection is not without point, yet it has much less 
weight than seems at first sight. The disutility of labor can 
act upon the supply and so upon the price of labor, not only 
by altering the length of the labor day, but also by diminish- 
ing the total number of labor days and the total number of 
men who labor at all. The first is especially conspicuous in 
times when the demand for labor is very great and the price 
very high. But at all times it probably plays a much larger 
part than is commonly supposed. A very considerable per 
cent, of the men who are engaged in the ordinary trades 
which we have in mind when speaking of labor in general, 
work a few days or weeks or months, and then loaf for a 
time, not hesitating even to give up the present job, confi- 
dent that they can easily find another. 

Doubtless the number of men who are ready to quit work 
altogether and thus reduce the supply when wages are in- 
adequate to cover the disutility as rated by them, is smaller 
than the number who quit work temporarily. Men are more 
loath to become dependent on relatives or "take to the road." 
But this number is after all not negligible. It helps to give 
the labor supply an elasticity sufficient to make disutility a 



FINAL PRICE DB TERM IN A TION 317 

real factor in the determination of wages. For we must 
remember, as in all these cases, that it is not necessary that 
all the supply of any factor should be ready to drop out: it is 
sufficient that an appreciable margin should be in this attitude. 

2. The Prices of Primary Cost-Goods and Significance 
or Utility 

A. Hypothesis of Only One Primary Cost-Good 

We come now to the most difficult part of our task, to 
show that the price of a primary cost-good must tend to ap- 
proximate a price which expresses its marginal significance 
in products. To simplify the proof, let us assume at first 
that there is only one primary cost-good and the stock of 
that cost-good is absolutely limited. 

Suppose this single cost-good is labor, and that a unit of 
labor is represented by L. Then all products would be, in 
effect, only so many Ls, — 3 Ls or 10 Ls or 50 Ls. In like 
manner, the significance of products — wheat, lumber, coal, 
etc. — would be, in effect, only the significances of the Ls, the 
units of labor, entering into them. 

Now let us assume that different kinds of products have 
very different degrees of generic importance, that wheat, for 
example, is more important than lumber, and lumber more 
important than coal. Assume, further, that the want sched- 
ules of wheat, lumber, and coal are rather inelastic so that 
the marginal significances or utilities of the three are con- 
siderably different in amount. Then, when equilibrium has 
iDeen established with our whole stock of Ls most wisely em- 
ployed, the price of one L, — a labor unit — would have to he 
■equal to the price of coal, the marginal product, divided by 
the number of Ls in that product. If it were greater than 
this, coal could not be produced ; if it were less, the spe- 
cial profit thus secured to entrepreneurs would lead them 
to compete for the possession of the Ls, and, so, would raise 
their price. 



3i8 PRINCIPLES OF ECONOMICS 

But the price of the marginal product which would de- 
termine the price of Ls in the way indicated would neces- 
sarily tend to approximate a price which would express the 
marginal significance of that product. That is, the price of 
coal, in the illustration, would tend to approximate a price 
which would express the marginal significance of coal. It 
could not be higher than such a price, since that would 
make consumers pay for coal more than it was worth to 
them; it could not go below such a price far enough to reach 
the marginal significance of the first extra-marginal prod- 
uct, say iron, since that would cause iron to compete for the 
stock of labor units, and so tend to cut down the output of 
intra-marginal products, coal, lumber, and wheat. But, if the 
price of one L must equal the price of its marginal product, 
coal, divided by the number of Ls in coal, and, if the price of 
coal must approximate a price which expresses the mar- 
ginal significance of that product, then the price of one L- 
must approximate the price which expresses its marginal 
significance in products. 

We have seen that, if there were but one primary cost- 
good and the stock of this were definitely limited, its price 
would necessarily approximate one which would express its 
marginal significance or utility. Would our conclusions be 
seriously altered if our one cost-good were producible and 
imposed a disutility upon those persons who supplied it?' 
Marginal disutility has entered into the problem and, as- 
shown in the preceding section, price will need to coincide 
with that quantity. Will this tend in any way to weaken our 
contention that it must coincide with marginal significance? 
By no means. Broadly speaking, significance and disutility 
are always moving in opposite directions, — marginal signifi- 
cance is declining as output increases, while marginal dis- 
utility is increasing as output increases. As a consequence,, 
there must be one price which expresses both marginal sig- 
nificance and marginal disutility. 



PINAL PRICE DETERMINATION 319 

B. Hypothesis of Several or Many Primary 
Cost-Goods 

It is now plain that we should naturally expect the price 
of a primary cost-good to be one which would express its 
marginal significance, provided there were hut one such 
primary cost-good to deal with. But this is very far indeed 
from representing the facts of life ; we have to deal with 
scores of primary cost-goods, instead of just one. It .is, in- 
deed, true that economists are wont to reduce these numer- 
ous elements to four, land, labor, capital, and responsibility- 
taking; and some have even reduced them to two. But this 
can be done only by making abstractions of more than ques- 
tionable validity; and, anyhow, all writers admit the exist- 
ence of at least two primary factors. But, again, not only 
are there several or many different primary cost-goods, these 
cost-goods are seldom, if ever, engaged in producing by 
themselves. In practically all cases, several of them are act- 
ing together in getting out some commodity. Accordingly, it 
becomes necessary to set up a hypothesis which involves 
these two very important conditions : ( i ) that there shall be 
many factors instead of one, and (2) that, in production, 
these factors shall practically always be acting jointly. 

These new conditions increase in a material degree the 
seriousness of our task of showing that the price of a pri- 
mary cost-good must express its marginal significance in pro- 
duction. The working of the processes which would tend to 
make the price of the single primary cost-good express its 
marginal significance is contingent upon the ability of pro- 
ducers to ascertain how significant is the unit of the cost- 
good and bid for it accordingly. Now, to get this knowledge 
offers no material difficulty when we are dealing with one 
cost-good. That one cost-good is responsible for the whole 
product and hence has the same significance or importance 
that the whole product has. But when several or many cost- 



320 PRINCIPLES OF ECONOMICS 

goods are acting jointly, how can we ascertain the degree of 
significance attaching to each one in that particular process? 
In my opinion, we can rarely, if ever, accomplish it at 
all. In many cases, we cannot isolate even the economic 
product of a factor which is jointly working with other fac- 
tors. In other words, the process which we depended upon 
in the one-factor hypothesis, — the competition of entrepre- 
neurs for cost-goods the real significance of which was per- 
fectly clear — this process fails us almost completely as soon 
as we enter an order where many factors are working in or- 
ganic combinations.* Nevertheless, I believe that the spon- 
taneous competition of entrepreneurs necessarily t ends' ;to 
give to each factor a price which expresses its marginal sig- 
nificance in production. The general character of the proc- 
ess referred to is expressed in the following thesis : 

The presence on the market of prices for primary cost- 
goods or factors different from the prices which would ex- 
press the marginal significances of those factors would of 
itself be sufficient to set up a series of reactions tending to 
replace the existing prices with such prices as did truly ex- 
press the marginal significances of the factors; and these 
reactions could not cease until the latter prices had been 
established. 

The argument supporting this thesis is not extremely dif- 
ficult, but it must be followed with care. If we proceed by 
way of a series of formal propositions, we shall perhaps keep 
our bearings more easily. 

I. Bach primary factor or cost-good really has its own 
specific significance in view of its uses in production. 

In order to establish this proposition, let us assume condi- 



* The opposite opinion is held by some economists of very high 
standing. In their opinion, it is possible to follow quite exactly the 
marginal product described on page 317, and, hence, to ascertain the 
real significance of each factor as measured in product. 



PINAL PRICE DETERMINATION 



321 



tions of such a nature that it will be impossible to ascertain 
directly the share of the product which is imputable to any- 
one factor. Suppose we have just three kinds of primary 
factors, designated Ls, Ws, Rs, or land, labor, and capi- 
tal ; that our stock or output of each is definitely fixed ; that, 
even after we have utilized our whole stock of each, we still 
have unsatisfied wants which the possible products of those 
factors could satisfy ; and that, when the stocks of these fac- 
tors are most wisely utilized, they are devoted to the making 
of three products, P-^, P2, P3, or spades, hoes, and trowels. 
Suppose, further, that the proportions in which Ls, Ws, and 
Rs may be combined is absolutely fixed for each product, and 
different for the different products, being 3 land, plus 2 la- 
bor, plus II capital for spades; 4 land, plus 10 labor, plus 2 
capital for hoes ; and 10 land, plus 3 labor, plus 3 capital for 
trowels. Finally, suppose that the values or prices of the 
three products, spades, hoes, and trowels are 62, 34, and 31. 

Now we have before us a set of conditions under which 
there seems to be no possibility of directly ascertaining the 
technical contribution of Ls or Ws or Rs. Yet even under 
these conditions, each of the factors involved, Ls, Ws, and 
Rs, has its own specific significance. 

In the first place, we are able to set forth a series of propo- 
sitions with respect to the productive capacities of our factors 
Ls, Ws, and Rs. 

3 Ls plus 2 Ws plus II Rs will produce i P-^ 

4 Ls plus 10 Ws plus 2 Rs will produce i Pg 
10 Ls plus 3 Ws plus 3 Rs will produce i P3 

In the second place, if we combine these propositions 
with the data as to prices of products stated in the last con- 
dition, we have the following equations : 

3 Ls -|- 2 Ws -|- II Rs = 62 cents 

4 Ls + 10 Ws -f 2 Rs != 34 cents 
10 Ls + 3 Ws 4- 3 Rs = 31 cents 



322 



PRINCIPLES OF ECONOMICS 



Solving these equations for each factor, we have the fol- 
lowing results : 

value I L ^= I cent 
value I W = 2 cents 
value I R t= 5 cents 

That is, under the conditions assumed, one L, (one unit 
of land) would have an importance or significance to us of 
I cent; one W, (one unit of labor) would have a significance 
of 2 cents; and one R, (one unit of capital) a significance of 
5 cents. We may conclude, then, that so long as different 
factors are combined in different proportions to produce dif- 
ferent commodities which sell at different prices, each factor 
will necessarily have its own specific significance, even though 
there is no way of directly ascertaining that significance. 

2. Assuming that each primary factor really has its own 
specific significance in view of its uses in production, we next 
affirm that prices for primary factors which did express their 
marginal significances — correct or right prices, we will 
call them — would guide production aright in respect to both 
the choice of goods to he produced and the combining pro- 
portions of factors to be used in the producing of those 
goods. 

So long as correct prices prevailed, entrepreneurs would 
be unconsciously led — led without any knowledge of the real 
significance of the primary factors — to pursue a correct pol- 
icy in the conduct of production; they would produce such 
goods and use such combinations as circumstances called for. 
By hypothesis, the prices in question truly express the signifi- 
cance of our store of primary factors when these have been 
assigned to their proper tasks in the proper proportion. 
Prices of which this is true could not misguide entrepre- 
neurs, could not lead them to err in the choice of goods to 
be produced or combinations to be employed, for a loss of 
profit would necessarily follow any such error. 



FINAL PRICE DETERMINATION 



323 



Thus in our former illustration, when the stock of three 
primary factors was most wisely employed, it was devoted 
to producing spades, hoes, and trowels. Let us suppose, in 
addition, that the proper quantity of spades was 500 units ; 
that of hoes was 10,000 units, and that of trowels was 100, 
000 units. Could the entrepreneur change these quantities 
without danger of loss? Surely not. For, if he should de- 
cide to withdraw some of the factors used in the producing 
of spades and put them to producing hoes, he would find the 
price of the latter falling below the 34 cents for which they 
had been selling, since this would be necessary to bring out 
some sub-marginal demand to take up the new supply. But 
their cost would still be 34 cents, for the prices of land, labor, 
and capital remain as before. He would, therefore, lose 
money by making such a shift. 

But not only would correct prices automatically lead en- 
trepreneurs to produce the right goods, they would also, un- 
der conditions of diversity in the combining proportions, au- 
tomatically lead entrepreneurs to choose the right combina- 
tions. First, the phrase "right combination" implies that, of 
the different possible combinations, there is one which, un- 
der a given set of circumstances, is the best one, — the correct 
one for that set of ci|pcumstances. Secondly, departures from 
this theoretically correct combination can be of only two 
kinds : (a) we may use so large a proportion of the less im- 
portant factors that we lose in efficiency more than we save 
in cost; and (b) we may use so large a proportion of the 
more important factors that we waste in cost more than we 
gain in efficiency. 

But the avoidance of these mistakes makes no call for 
super-human knowledge as to what are the really correct 
combinations. Combinations which err in having too large 
a proportion of less important factors will promptly disclose 
this fact in small or inferior output; thus, a potato patch re- 
ceiving too much capital expense in the way of seed and fer- 
tilizer and too little labor expense in the way of cultivation 



324 



PRINCIPLES OP ECONOMICS 



would certainly produce an unsatisfactory crop of potatoes. 
On the other hand, combinations which err in having too 
large a proportion of more important factors will promptly 
disclose this fact in too great cost per unit of product; a po- 
tato patch receiving too much labor expense and too little 
capital expense might produce many potatoes of high grade 
but, however excellent the crop, it would not pay for the 
labor. Either of these results would quickly lead entrepre- 
neurs to discontinue the use of the wrong combinations. 

3. If our contention that correct prices for primary fac- 
tors, — prices which expressed their marginal significance in 
products — would correctly guide production, has been at all 
convincing, little argument for the complementary proposi- 
tion seems needed. Wrong prices for primary factors — 
prices which failed to express their marginal significance — 
would guide production wrong, — would lead entrepreneurs 
to produce the wrong things or use the wrong combining pro- 
portions. 

The course of causation is fairly plain. The lower the 
price of any factor, the stronger the motive which entrepre- 
neurs will have for producing those goods and using those 
combinations which call for that factor in large amounts. On 
the other hand, the higher the price of any factor, the strong- 
er the motive which entrepreneurs will have for producing 
those goods and using those combinations which call for that 
factor in small amounts. Now, admitting the point made 
above, that correct prices for the different factors would lead 
entrepreneurs to adopt a correct policy, it follows necessarily 
that prices higher or lower than these correct ones would 
tend to alter the policy of entrepreneurs in respect to the 
goods produced and the combining proportions used, would 
lead them to adopt an incorrect policy. More particularly, 
they would produce too many goods in the producing of 
which the underrated factors played a large part, too few 
of the goods in the producing of which the overrated factors 
played a large part. At the same time, they would employ 



PINAL PRICE DETERMINATION 325 

too much the combinations in which the underrated factors 
appeared in abnormal proportion, and would employ too lit- 
tle the combinations in which the overrated factors appeared 
in abnormal proportion. Thus, if coal mining requires much 
capital and little labor, and lumbering requires much labor 
and little capital, and if at a certain time capital is rated 
higher than its real worth and labor is rated lower, then 
there will be too little production of coal and too great a 
production of lumber. 

4. We have shown that incorrect prices for primary fac- 
tors would inevitably lead entrepreneurs to the adoption of 
an incorrect policy in the conduct of production. We now 
put forward the proposition which brings our long argument 
to a conclusion. The incorrect policy into which entrepre- 
neurs would he led by the presence of incorrect prices for 
primary factors — prices which failed to express the true 
marginal significance of those factors — would inevitably set 
up reactions zvhich coidd not cease till they had effected a 
correction of those very prices which had zvorked the mis- 
chief. 

The reasons are plain. Supposing the case to be one of 
an abnormally high price for some factor — a price leading 
entrepreneurs to cut down their use of that factor — the de- 
mand for the factor would fall below the stock or natural 
output, making some portion of the stock superfluous, and 
this would necessarily cause a fall in the price of the factor; 
and this process could not cease until the price had reached 
its natural level. If, on the other hand, we suppose the case 
to be one of an abnormally low price for some factor — a 
price leading entrepreneurs to increase their use of that fac- 
tor — the demand for the factor at the going price would be 
in excess of the stock; a condition which would necessarily 
bring about a rise in its price ; and this process could not 
cease until the price had reached its natural level. 

It thus appears that the prices for primary factors or cost- 
goods which truly expressed their marginal significance and 



326 PRINCIPLBS OF ECONOMICS 

these only could maintain themselves tinder the automatic 
working of economic forces. The prices of such primary fac- 
tors must, therefore, fulfill this condition. 

Section B. The Determination of the Prices of Produced 
Goods as a Complete Process 

We have explained how the prices of primary cost-goods 
or factors are determined. We need now to show how the 
processes determining the prices of these cost-goods relate 
themselves to the immediate processes whereby the prices of 
produced goods are determined. In other words, we need to 
set forth a theory for the determination of the prices of pro- 
duced goods as a complete process. Whether or not it 
would, in any case, be possible to do this at all adequately, it 
certainly is not possible with the space at our command. We 
must content ourselves with an outline so bare that it does 
nothing more than indicate the most central relations. We 
shall confine ourselves almost entirely to a general hypothesis 
so simple and so far from reality that it might perhaps be ex- 
pected to give results of no significance in relation to the 
economic world as it is. I believe, however, that it will con- 
tribute in some degree to our understanding of a very diffi- 
cult matter. And, at all events, it is certain that any attempt 
to present the matter in a more concrete way could end only 
in failure. 

We shall suppose that there is but one primary factor, 
which we will designate by the letter L, that this is strictly 
limited in amount, and that it produces consumption goods 
directly, — without the intervention of intermediate products. 
The working of this hypothesis we will consider under each 
of two additional conditions: (i) the supplying of the sin- 
gle primary factor does not involve any disutility, (2) sup- 
plying that factor does involve a disutility. 

Let us begin with representing our single primary fac- 
tor by the letter L, and the different products which we need 



FINAL PRICB DBTBRMINATION 327 

by the letters P-^, Po, P3, P4, Pg, Pg, naming them in the 
order of marginal, as well as generic, importance. If the 
student needs more concreteness in thinking out the prob- 
lem, he may substitute actual products for these letters, for 
example, wheat, lumber, coal, iron, wool and copper. It 
should be understood, however, that any series so chosen is 
used for illustration only, for it could not, in actuality, con- 
form to all the needs of the argument. We shall limit our- 
selves here to a highly abstract presentation. 

Let us suppose, now, that our stock of the primary cost- 
good, L, is such that we can satisfy our needs for these first 
six products, but can go no further; that, when our produc- 
tion and consumption are most wisely adjusted, the marginal 
significances of our six products are respectively $120, $80, 
$48, $24, $12, and $4; and, finally, that our products, P^, P,, 
etc., contain respectively 12 Ls, 10 L,s, 8 Ls, 6 Ls, 4 Ls, 
and 2 Ls. 

iL $I0-« ^I2Ls$I20-« * iPi $I20-«- 

iL $ 8-< — * 10 Ls $ 80 < — * 
XL $ 6 < — * 8 Ls $ 48 -< — < 
iL $ 4 •< — ^ 6 Ls $ 24 ■< — 4 
iL $ 3 < ^ 4 Ls $ 12 -* — < 
iL$2-< — A 2 Ls $ 4< — < 

Fig. 4 

Now, it is sometimes carelessly assumed that each prod- 
uct has its price determined by its own taarginal utility 
solely. On such a theory, we should have the results repre- 
sented in the accompanying diagram (Fig. 4). The marginal 
significance of P^ being $120, would make its price $120, which 
would make the price of the 12 Ls entering into it $120, which 
would make the price of one L $10; so the marginal signifi- 
cance of P2 being $80, would make its price $80, which would 
make the price of the 10 Ls entering into it $80, which would 
make the price of each L entering into it $8; and so on. But 




328 



PRINCIPLES OP ECONOMICS 



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Q? 



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o o 



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cOq_ 



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— , C O 

D ^ 
«:> (/; lL 



y o 



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p; o' CO* ^ c\) 

£^ CO -"sT CM -^ 

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Or C^ £D m OD 

ui LO uy CO </y 



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CM c\j — — 

■te- 
ll ij II II II 

cr ^ Q? D^ D^ 

A A A A A 



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"^11 II II 11 II 

e> <0 <g <o >9 

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05 



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LO 



FINAL PRICE DBTBRMINATION 329 

obviously, this result would be impossible ; we should have in 
the same market at the same time, six different prices, $10, $8, 
$6, $4, $3, and $2, for the same commodity, one L. 

The real course of things would be quite different. Sup- 
posing numerous reactions to have brought about a state of 
equilibrium, the starting point of price-determination would 
be in the marginal significance of the sixth product. This 
element being fixed at $4 would make the price of Pg $4, 
which would make the price of the 2 Ls contained in Pg $4, 
which would make the price of each of the Ls contained in it 
$2, and this would make the price of every L $2. The price 
of Ls now fixed at $2, would proceed to determine the prices 
of P„ P„ P3, P„ and P,. 

This method of explaining the course of causation among 
significances and products and cost-goods which represents in 
a general way the Austrian theory of final price-determina- 
tion, is diagrammatically brought out in Figure 5. It may 
be summarized in the following four propositions : 

1. The marginal significance of ithe marginal product 
having been determined, determines the price of that prod- 
uct; 

2. The price of the marginal product having been de- 
termined, determines the price of each of the Ls entering 
into it; 

3. The price of the Ls entering into the marginal prod- 
uct having been determined, determines the price of all 
other Ls; 

4. The price of Ls in general having been determined, 
determines the prices of the supra-marginal products. 

In this analysis and diagram our statement of the general 
problem of price determination is not quite complete. We 
have seemed to go on the assumption that the marginal sig- 
nificance of the marginal product is alone in determining the 
price of the primary cost good. But, as we have already seen, 
the marginal disutility of supplying a primary cost good also 



330 



PRINCIPLBS OF ECONOMICS 



plays a part in fixing its price. This being true, it is not 
enough to say that, when spontaneous reactions have brought 
equilibrium, the marginal significance of the marginal prod- 
uct determines the price of the primary cost-good, which 
thereupon determines the prices of the supra-marginal prod- 
ucts. Instead, we must say : when the natural reactions have 
brought about an equilibrium, the marginal significance of 
the marginal product plus the marginal disutility of supply- 
ing the primary cost-good determine the price of the primary 
cost-good, which thereupon determines the prices of the su- 
pra-marginal products. 

This amended theory could be diagrammatically presented 
in another figure. The diagram would be in the main identi- 
cal with Figure 5, but would include another column to repre- 
sent the marginal disutilities of supplying the different quanti- 
ties of Ls. If only enough Ls to produce P^s has to be sup- 
plied, the marginal disutility of supplying Ls is represented 
by $1 ; if enough for PgS also must be had, the marginal 
disutility increases to $1.10; if P3S also must be pro- 
duced, it becomes $1.20; and so on. As the situation neces- 
sarily turns out, production is carried forward until the mar- 
ginal disutility of supplying Ls is $2; at which figure, price 
also settles. And this price is necessary just as much because 
the marginal disutility of Ls is $2 as because its marginal 
significance in Pg is $2. 

Section C. The Interdependence of All Prices 

One more point must close this long but inadequate ac- 
count of the more fundamental aspects of the price problem. 
That point may be set forth in the following formal state- 
ment. 

All prices, especially the prices of produced goods, are in- 
terdependent; and equilibrium among the price-making forc- 
es can be approximated only when all prices have come to 
form a coherent, self -consistent system. 



FINAL PRICE DETERMINATION 331 

One reason why the prices of many economic goods are 
necessarily interdependent is that the goods have common 
origins, are derived from common factors or cost-goods. 
Thus the price of steel rails could not be determined inde- 
pendently of the prices of knives, saws, and girders, because 
all these commodities are alike made from steel, and so their 
prices will all alike be affected by the price of steel. The 
price of any such product could be determined independently 
of the others only in case the steel used in making them were 
sold, in the same market at the same time, for different prices 
corresponding to its different uses. But such a state of things 
we have already shown, in the law of Single Price, to be im- 
possible. 

But, admitting this point, cannot the prices of all prod- 
ucts made from one particular kind of razv material be de- 
termined independently of the prices of products made from 
other kinds of raw materialsf For example, though the 
prices of rails could not be determined independently of the 
prices of engines, girders, saws, planes, and knives, still the 
prices of all products made from steel could surely be deter- 
mined independently of the prices of all products made from 
lead or copper or zinc or wood. On the contrary, this doc- 
trine is scarcely less absurd than the former. Like the steel 
knives, steel saws, and steel girders referred to in our first 
example, products made from steel and products made from 
lead, copper, and zinc also have common sources, — the hu- 
man labor of many different kinds and the capital or waiting- 
power which is required in all the industries concerned. Con- 
sequently if the prices of products made from steel were to 
be determined independently of the prices of products made 
from lead or zinc or copper, then the different kinds of labor, 
the waiting-power, and the other factors which constitute 
common sources for steel, lead, zinc, and copper — would 
each have to have many different prices in the same market 
at the same time, in contravention of the Law of Single 
Price. 



332. PRINCIPLES OF ECONOMICS 

A second reason why many prices are interdependent is 
that the goods to which they belong are related to each other 
as cost-good {or factor) and prodtict. If the prices of dif- 
ferent products made from steel cannot be independent of 
one another, it is even more obvious that the price of steel 
and that of any product made from it cannot be independent 
of one another. This conclusion is unavoidable whatever 
theory we may hold as to the direction of causation between 
factor and product. 

The price of the cost good may be what it is because the 
price of the product is what it is, or the price of the product 
may be what it is because the price of the cost-good is what it 
is ; but surely one or the other or both must be true. It is 
not possible that each of these prices should be uninfluenced 
by the other. The total of cost-goods entering into any prod- 
uct is economically interconvertible with that product. To 
have that total as our property is, virtually, to have that 
product. The two things are, in effect, the same thing. But 
the same thing cannot have two prices in the same market 
at the same time. One of these two must compel the other 
to have the same price as itself. Their prices are necessarily 
interdependent. 

A third ground for afifirming the interdependence of pric- 
es is found in the fact that many goods occupy to each other 
the relation of reciprocal substitutes, — if the price of one is 
too high, the other may be substituted therefor. Electric 
lighting companies cannot advance their rates indefinitely be- 
cause of the competition of gas or kerosene ; too expensive 
wool will be conserved by a greater use of cotton for wearing 
apparel; high prices for meats will increase the consumption 
of vegetable foods. These changes in the direction of de- 
mand will, obviously, tend to cause corresponding changes in 
prices. The price of one commodity will tend to fall, while 
that of its substitute will tend to rise. 

Finally, all prices are necessarily interdependent because 
in a broad but legitimate meaning of the language, practically 



PINAL PRICE DBTBRMINATION 



)33 



all goods occupy toward one another the relation of recip- 
rocal substitutes. Each is competing against every other for 
the opportunity to satisfy our wants. A rise in the price of a 
commodity destined for the satisfaction of a particular want 
is Hkely to cause us to satisfy that want less adequately or 
perhaps not at all, because a commodity which is adapted to 
the satisfying of some other want can be had more cheaply. 
This possibility tends to lower the price of the former com- 
modity and raise that of the latter. And, of course, a fall in 
the price of the former commodity will tend to have the op- 
posite effect, that is, to compel a decline in the prices of 
other and competing commodities. 

We have shown the soundness of the first part of our 
general proposition, which says that all prices are interde- 
pendent. The second part follows as an immediate inference 
from the first, and should call for no other argument. Since 
all prices are interdependent, are reciprocally determined, re- 
actions among them cannot cease — equilibrium cannot be 
reached — till they together form a coherent, self-consistent 
whole. 



CHAPTER XXI 

SPECULATIVE TRADING AND INSURANCE 

In this chapter we purpose to comment briefly on two 
forms of economic activity a knowledge of which has not 
seemed quite essential to the development of our study, but 
which, certainly, we ought not to ignore altogether. These are 
Speculative Trading and Insurance. 

It must be manifest by this time that risk, the risk of loss, 
both physical and economic, is an ever-present element in eco- 
nomic life. There is constant danger that goods shall under- 
go physical destruction or deterioration, and danger that the 
value — the economic significance — of goods shall decline. 
Now these risks being ineradicable elements in economic life, 
individuals, or society as a whole, must in some way bear 
them. As has already been brought out again and again, a 
large number of the risks incident to productive activity are 
borne by the central figure in production, the entrepreneur. 
It has indeed been maintained by some writers that not only 
the entrepreneur's greatest, but his only, function is the as- 
sumption of the risk of production. The position on this point 
taken in the present text has been somewhat less extreme. We 
recognize that the assumption of the responsibility of produc- 
tion involves some other burdens as well as risk-taking, in- 
cluding some very general types of labor. Nevertheless it 
must be admitted that the chief part of the entrepreneur's 
task or function is to bear risk. 

Again, as has been explained in other connections, risks 
are chiefly of two types : ( i ) those which regularly recur and 
so are calculable and (2) those of irregular nature which can- 
not be reduced to any law of recurrence. The entrepreneur's 
function in risk-bearing is especially connected with the 
second type. But he is not the only one who contributes to the 



SPBCULATIVE TRADING AND INSURANCE 335 

bearing of this burden. In fact, no economic person can be 
completely rid of it; and one person especially, the man who 
engages in speculative trading, shares in it very largely. Our 
first section, therefore, is given to an account of speculation 
or speculative trading. 

I. Speculative Trading 

The nature of speculation can best be realized by contrast- 
ing it with related functions and operations. As already not- 
ed, speculation is akin to the function of the entrepreneur in 
that it assumes non-calculable risks. It differs, however, in 
that it frequently divorces this assumption of risk from own- 
ership ; whereas the distinctive mark of the risk-bearing of the 
entrepreneur is that he assumes that burden by the process of 
becoming the owner of the goods. He assembles the various 
productive elements necessary for bringing a commodity in- 
to existence and accepts the responsibility from first to last, 
including the ownership of the products when completed. The 
speculator in the narrow sense does not necessarily do this ; in 
fact, a very characteristic feature of his trading is the cutting 
apart of these two functions. Thus men who purchase wheat 
in large amounts and store it for sale at a future time com- 
monly turn over to some one else the burden of bearing the 
risk of possible loss between the purchase and the sale of 
such wheat by selHng against it other wheat for future de- 
livery. 

Again, speculative trading is distinguished from ordinary 
or so-called legitimate business in that it expects to make a 
profit out of changes in the prices of commodities in the same 
market ; whereas ordinary trade expects to get its profit out of 
price dijferences in different markets. To illustrate, the spec- 
ulator in wheat on the Chicago market buys wheat today ex- 
pecting to sell it at a later date in the Chicago market when 
the price* shall have advanced. He very likely sells to an- 
other person like himself who deals in the goods for the 
same purpose of making a profit through purchase and sale. 



336 PRINCIPLES OP ECONOMICS 

In contrast, the ordinary dealer in a product of wheat, say 
bread, expects to make his profit by being able to sell at a 
price slightly in advance of the price at which the baker sells 
it to him. It should perhaps be added that some admixture 
of speculative trading is often present in ordinary business 
or at any rate may be so present. Ordinary dealers of specu- 
lative temperament will every now and then load up with an 
unusually large stock of some commodity, the price of which, 
in their opinion, is Hkely to advance. This is in the strictest 
sense speculation, not what is commonly called legitimate busi- 
ness. 

We have distinguished the risk-bearing of the speculator 
from that of the entrepreneur and his type of dealing from 
that of the ordinary trader. We need also to distinguish 
speculation from gambling with which it is often identified. 
Gambling, as pointed out in other connections, has, from the 
economic standpoint, this distinguishing mark: it involves 
the assumption of a needless risk. In many cases the risk is 
created for the occasion. For example, the gambler throws a 
pair of dice out of a box, betting on which side will turn up. 
On the other hand, gambling may take place in connection 
with chances which naturally exist, for example, in the out- 
come of some notable series of events, an election or a war. 
But although the chance is here of natural origin, the assump- 
tion of economic risk with respect to that chance is not of nat- 
ural origin. It is entirely artificial. It is, for the moment, 
uncertain whether Mr. Wilson or Mr. Hughes will be elected ; 
the uncertainty, the chance, is here anyhow; but I am not 
driven to assume any economic risk in connection with this 
uncertainty. In contrast with gambling, speculative trading 
not only involves inevitable uncertainty and chance, it also in- 
volves a necessary economic risk. The price of wheat may 
fall between September and March. In fact it is practically 
certain to change. No man experienced in such matters will 
anticipate the recurrence of precisely the same price six 
months from date. This element of uncertainty or chance 



SPBCULATIVB TRADING AND INSURANCE 337 

must necessarily entail loss to some one. If it should be a 
fall, the present owner will lose ; if it should be a rise the per- 
sons who will need to purchase the wheat will inevitably lose. 
Speculation is, therefore, not gambling, but, within limits, the 
performance of a necessary economic function. 

The most thoroughgoing forms of speculative trading are 
carried on in special markets, of which the wheat, cotton, and 
stock exchanges — called bourses on the continent of Europe — 
are the most conspicuous examples. These markets have as 
their most notable characteristics the following: 

(a) Trading in common. The majority of the dealers 
taking part are brought together in one place at the same 
time ; buyers competing with buyers and sellers with sellers. 

(b) Another characteristic is open-trading. There is no pri- 
vacy as respects the dealings. The amounts, prices, and so 
on are at once announced and recorded by the proper officers. 

(c) The trading is through official dealers, brokers, as they 
are ordinarily called, (d) The dealings are usually on a 
very large scale. 

(e) The major part of the trading is speculative. There 
is, of course, some selling by persons who have produced the 
goods and brought them to the market for disposal, and so 
there are some persons who have come to the market to buy 
for actual use outside. This last is illustrated by men in the 
milling district who purchase their wheat supply in large 
amounts, at these exchanges. But the major part of the 
dealings, probably more than 90 per cent, of them, are carried 
on by men who are engaged in speculation as such. By this 
is meant that they are not, if buyers, intending to make any 
use of the product, while if sellers, they are not producers or 
ordinary middlemen who are bringing the goods to market. 
What they are doing is attempting to make a gain, if buyers, 
by getting at one price and presently selling at a higher one. 
If sellers, they have already purchased at a low price and are 
now reaping the gain resulting from the advance. Or they 
may be selling for future delivery, agreeing to deliver the 



338 PRINCIPLES OP ECONOMICS 

goods at some future date, confident that they will be able to 
make the necessary purchases at the time of delivery at a 
lower price than that agreed upon. 

(f) This last statement suggests another characteristic 
of produce speculative trading, namely, dealing in futures. 
By this is meant nothing more than contracting to deliver or 
to accept at some future time a quantity of goods at a price 
now agreed upon. Such contracts for future delivery are of 
course present in all Hues of business. We order a suit of 
clothes, we order wood, or coal, to be delivered at some future 
time, the contractor orders structural steel and lumber in ad- 
vance of the time when he will need it. But the future trad- 
ing of the speculative market differs from these cases in that 
it is not something occasional, growing out of a special need 
of the consumer or producer, but is systematically and con- 
stantly entered into for the sake of the possible profits to be 
obtained, or for some other ends which will be explained in 
a moment. 

It may contribute to our understanding of this matter to 
note some of the technique of the speculative market. As 
stated above, the dealers directly concerned in the processes 
of buying and selling are known as brokers, and they are con- 
stantly taking and fulfilling orders. (The brokers, however, 
are usually supposed to refrain from personal dealings, and 
to buy or sell only on the account of other persons.) The 
real dealer in the transaction is commonly some outside par- 
ty, perhaps located in a remote city. 

Some of the dealers on the market habitually deal with 
the expectation of making a profit from a rise in prices; that 
is, they buy today with the intention of selling later when 
prices have advanced. They are known as bull speculators, 
or simply bulls. In contrast, some dealers habitually antici- 
pate and deal with an eye to a fall in prices. Such dealers sell 
for future delivery, — "go short," is the expression frequently 
used. They agree to deliver certain goods which they do not 
at the present moment own. Dealers of this type are known 
as bear speculators, or simply bears. 



SPECULATIVE TRADING AND INSURANCE 339 

Human nature being what it is, the latter group is usually 
smaller than the former. On most stock exchanges, in this 
country at least, the rules require the delivery of the goods 
sold within twenty-four hours. By hypothesis, however, the 
dealer is not in possession of those goods. It, therefore, be- 
comes necessary that he should borrow from those persons 
who do own the required stock. As a rule, he has no diffi- 
culty doing this because the owners are glad to be released of 
the burden of interest-bearing which ownership involves. Cir- 
cumstances may arise, however, under which the demand for 
stock to deliver on short sales is so great that it is practically 
impossible to find enough stock to meet the emergency. The 
result is a crisis to the bears in which great sums are lost. 

Another bit of technique of importance is the so-called 
margins and marginal trading. Everywhere in business 
life there is dealing on borrowed capital. Probably the ma- 
jority of traders in all highly-developed countries, depend on 
the capital of other people for a considerable part of that 
which is needed in their business. They borrow outright 
from capitalists on personal notes, or they meet any particu- 
lar bill from wholesalers by raising a special sum for that 
emergency. Essentially the case is no different in margin 
trading on exchange. That is, the purchaser wishes to buy 
live hundred shares of Pennsylvania stock and has not more 
than a tenth of the capital necessary to do so. He naturally 
desires to borrow the rest of the money needed from some 
one else. This is particularly easy in stock transactions or 
speculative transactions generally for the reason that the se- 
curity is readily realized upon and very efficient machinery 
for facilitating the process has been built up. The man who 
wishes to make such a purchase, therefore, deposits with his 
broker that portion of the purchase price which he himself 
expects to pay, authorizing the broker to borrow the rest of 
the money needed. The sum which he deposits with his 
broker to cover his part of the money advanced is called a 
margin and trading of this type is known as marginal trad- 
ing. 



340 



PRINCIPLES OP ECONOMICS 



As explained above, this borrowing is in essence no differ- 
ent from borrowing in other Hnes of business. In practice, 
however, it is a more dangerous type. This is partly, of course, 
due to the more dangerous character of the business. In ad- 
dition, the facilities given tempt dealers to go into the specu- 
lation on a much larger scale than their own capital will war- 
rant. It is always provided that the broker can dispose of 
the stock he holds as security for the loan whenever his client 
fails to maintain his margin, and this of course makes that 
broker perfectly willing to lend to the limit of reasonableness. 

The last remark suggests two or three other technical 
phrases employed in speculative trading. To keep up one's 
margin is to send in more money if at any time the change 
in the value of the stock makes the previous margin inade- 
quate. So when the broker realizes on the loan he has made 
by selling the stock of his client he is said to close him out. 

We have seen that speculation is one of the several methods 
by which the risk burden incident to all economic life is 
borne.* And this risk-bearing naturally would be thought of 
as the primary function of speculation. A second, perhaps 
equally important function is maintaining conditions for the 
determination of the right price. Let us now consider more 
carefully these two functions in detail. 

The way in which speculation carries out its primary 
function of assuming the burden of risk-bearing is best illus- 
trated in the wheat business. As already remarked, it is in- 
evitable that there should be losses unmerited and gains un- 
merited from changes in the price of any commodity from 
one part of the year to another. Further, there will be per- 
sons in the community who are not fit to assume this burden, 
although so situated that they will be forced to do so unless 
some device is created whereby the burden can be unloaded. 
Thus, millers must have wheat, and they must buy it consid- 
erably in advance of the time when they can market the flour 

* From the standpoint of society at large it is a cheap and effi- 
cient method of bearing these risks. 



SPBCULATIVB TRADING AND INSURANCE 341 

made from that wheat. But in the interim the price of wheat 
may fall greatly and as a result the price of flour will fall. 
The millers will therefore be liable to a serious loss growing 
out of this possible change in prices. 

It might be argued that this is only one of the inevitable 
burdens of their particular function in industrial life and so 
they ought to bear it without murmur. A very characteris- 
tic feature, however, of modern industrial life is extreme spe- 
cialization, — the working out of devices whereby the differ- 
ent burdens of productive activity can be separated and as- 
signed to different agents. Now the miller has as his primary 
function the turning of zvheat into flour. It is his perform- 
ance of this service that entitles him to a living. He has no 
ambition to speculate in wheat as such, to make a living by 
dealing in this commodity so subject to changing prices. He 
would therefore be glad to utilize some device whereby this 
part of the burden would be thrown onto some one else. 

The wheat exchange fills his need exactly. He wishes 
to buy, let us say, ten thousand bushels of wheat to be turned 
into flour in the course of the next few months. Accordingly, 
he gives an order to a broker on the Chicago exchange for 
that amount of cash wheat, that is, of wheat to be delivered 
at once. At the same time he orders the broker to sell for 
future delivery at the date when he expects to have his flour 
ready for the market, ten thousand bushels of wheat, — the 
price being fixed at the present moment, in relation to the 
present price of cash wheat. In the fall of the year this will 
mean a higher price for future deliveries because of the 
cost of storing, insurance and interest on the investment. Now 
when the future period comes he will get for the ten thousand 
bushels of wheat the price agreed upon anyhow. If, in or- 
der to meet this sale that he has made, he has to pay a higher 
price than was anticipated, he loses on the deal, but makes a 
corresponding amount from the advance of his flour. On the 
other hand, if at that time he is able to buy in the wheat for de- 
livery at a lower price, he gains on this future deal, but loses 



342 



PRINCIPLES OF ECONOMICS 



on the flour which has fallen because of the fall of wheat. In 
short, the net resultant of the whole transaction is that he 
neither gains nor loses by changes in the price of wheat. He 
is thus limited to what he calls legitimate business, the mill- 
ing business, the turning of wheat into flour. Out of that he 
makes his living and leaves other people to speculate in wheat. 
It will contribute to a better understanding of this explana- 
tion to follow an imaginary transaction in detail. 

Let us suppose that our milling company sets out to sup- 
ply itself with wheat at a time when that grain is quoted for 
immediate delivery at $i and for future delivery at $1.04. 
Our problem, then, is to determine by experiment what the 
result will be when the transaction is quite ended for each of 
the different possibilities as to the price actually prevailing 
when the future deal is consummated. Manifestly, these pos- 
sibilities will be covered by three hypotheses : a price at the 
future date exactly equal to the expected one, $1.04; any price 
higher than the expected one, say, $1.10; and any price lower 
than $1.04, say, $.90. The three tables following give the re- 
sults for these three hypotheses in their order. Each time the 
net result is neither gain nor loss. 

TABLE I 
Cash Wheat Future 
Original cost $10,000 Cost $10,400 

Storage, insurance, etc. 400 

Total cost $10,400 

Value 10,400 Selling value 10,400 



Gain or loss $00,000 Gain or loss $00,000 

TABLE 2 
Cash Wheat Future 

Total cost $10,400 Cost $11,000 

Value 11,000 Selling value 10,400 



Gain $ 600 Loss $ 600 



SPECULATIVE TRADING AND INSURANCE 



343 



TABLE 3 
Cash Whi:at Future 

Total cost $10,400 Cost $ 9,000 

Value 9,000 Selling value 10,400 



Loss $ 1,400 Gain $ 1,400 

Illustrative Problems 

A Liverpool miller buys through a Dutch commission 
house 30,000 bushels of wheat, paying 93 cents a bushel, and 
at the same time sells 30,000 bushels for May deHvery, the 
price being 95^ cents. 

(a) Assuming that 2^ cents covers the cost, (storage, 
insurance, and interest) of carrying the wheat from the date 
of purchase till May, show that the miller will lose nothing 
on the wheat even if by May the price should fall to 70 cents. 

(b) Would he gain if the price should rise to $1.10? 
Prove. 

(c) What did the word "carrying" in the second sen- 
tence of the problem mean? 

We have explained the primary, central function of spec- 
ulation, the assumption of the risk burden of a particular 
type of economic activity. The second of the two functions 
mentioned above — working out a proper price — must be com- 
mented upon briefly. As already so often remarked, price is 
the pre-eminent regulative mechanism of the present eco- 
nomic order. And we mean by right price that price which 
will regulate economic activity in accord with the demands of 
the situation as a whole. Now it is manifestly of the utmost 
importance that the right price should prevail. If there is 
likely to be a diminution of the acreage put into wheat be- 
cause of the outbreak of the great war it is highly important 
that something should happen to induce countries unaffected 
by the war to increase the amount of wheat which they raise. 
But of course nothing can contribute so effectively to this 
result as an advance in the price of wheat, and that an early 



344 



PRINCIPLBS OF ECONOMICS 



advance. But again nothing can so surely bring about this 
much-needed result as the efficient working of a great spec- 
ulative market. 

In these great markets we have a large number of compet- 
ing dealers on both sides, men of exceptional capacity, keen- 
ness, and knowledge, furnished with every facility for getting 
information regarding the probabilities of demand and pro- 
duction in all parts of the world. In consequence, if there is 
good reason to believe that prices should naturally change, 
that the conditions of demand and supply will create in the 
near future a much higher price, that higher price is likely 
to be brought into existence much sooner, much more com- 
pletely than without such a market. This was exactly what 
happened in the summer of 19 14 at the outbreak of the great 
War. It happened again in the summer of 19 16 when the 
failure of the processes was in prospect, and it was just 
what ought to have happened, although it was constantly mis- 
interpreted and lamented by men of affairs thoroughly un- 
familiar with the working of economic laws. The sharp ad- 
vance in the price of wheat meant that the farmers who could 
produce winter wheat, which has to be sown in the fall of the 
year, would promptly improve their opportunity, would pro- 
ceed to increase the acreage as rapidly as possible. A rise in 
price which had waited for months till after the consumer 
began to feel it clearly, would have been too late to bring 
the needed result. An advance in price brought about early, 
before any but the trained and well-informed speculator could 
anticipate the whole result, was just the thing which the sit- 
uation called for. 

2. Insurance : Its Nature and Functions 

The essential nature of insurance consists in the pooling, 
putting into one mass, of a large number of risks. In other 
words, the many persons interested act, for this particular 
purpose, as if they constituted just one person. Thus, if the 
individual owners of a thousand houses desire to insure 



SPBCULATIVE TRADING AND IN SU RANCH 345 

themselves against loss by fire, they proceed to act in the 
matter as if all the houses were owned by them as a group. 
If any house burns down, the group replaces it by contribu- 
tions raised from all members of the group. Otherwise the 
houses are treated as if owned by individuals, but in this re- 
spect they are treated as if owned by the group. 

Now the function of this economic activity, this industry, 
if you please, is readily seen by considering the advan- 
tage derived from the practice indicated. If, in the illus- 
tration, we suppose each house to be worth $2,000, then- with- 
out such pooling as insurance provides, the burning of one of 
these houses would mean a total loss to the owner, a loss of 
$2,000. On the other hand, if pooling takes place, the result 
of the fire is that each owner loses $2. The advantage of 
such a procedure, supposing only a few houses burn down, 
is manifest. Each owner is, indeed, obliged to lose something. 
But this amount is quite small and in exchange for it he is 
saved from the risk of losing his whole $2,000. In other 
words, the individual's advantage from insurance may be 
summarized as the substitution of a series of small, though 
certain, losses for the chance of a great loss.* But this means 
that insurance makes less burdensome to the individual the 
risk incident to economic ownership. Accordingly, the func- 
tion of insurance is to secure the easier hearing of risk. 

The preceding account seemed to deal only with what is 
called mutual insurance, — insurance in which the parties in- 
sured are responsible for the procedure, manage the whole 
business. But most insurance, as we know, is not technically 
of this character. Instead, it is undertaken by a great cor- 
poration which "sells" insurance, as the agent would say, as 
other corporations sell gas or electrcity. Has our account 
covered this case? Surely, yes. In essence, all insurance is 



* This surely is a social as well as individual advantage. The 
strain upon industry, the loss of efficiency due to the falling of a 
great loss upon a single individual is much greater than that of a tri- 
fling loss experienced by many individuals. 



346 PRINCIPLES OP ECONOMICS 

mutual. The fund from which the company makes good the 
losses to householders whose houses burn in reality comes 
not from the company but from all the householders. If these 
were not making regular payments adequate to cover the total 
losses of the group, the company would have nothing to pay. 
The only difference between this case and that of strict mutual 
insurance is one of management, procedure. In the latter, 
the insured householders organize to manage the business 
themselves, accepting all the responsibilities and burdens. In the 
former case, speculative insurance it is often called, a corporate 
entrepreneur undertakes to carry out the plan, assume all the 
responsibilities, and do the necessary work. The essence of 
the matter is as before the pooling of risks, the acting as one 
owner in respect to the burden of ownership. 

It should be said also that while the foregoing account of 
insurance dealt only with loss from fire, an exactly similar 
analysis would fit the case for insurance against any type of 
economic loss, for example, cyclone, shipwreck, colli- 
sion, etc. 

The last remark suggests that we need some comment on 
the question: Under what conditions is the insurance princi- 
ple, the principle of pooling risks in order to diminish their 
economic burden appHcable? The answer is this: the insur- 
ance principle can be used wherever risks are fairly calculable. 
If we can prove statistically that, when any large body of 
losses are taken together, the per cent, of loss is only mod- 
erately high, and fairly regular, insurance is feasible. Doubt- 
less this is a somewhat vague rule; but it has answered in the 
building up of great businesses. With the improvements in 
statistical art, and the enlargement of the pools, it has been 
possible to extend the operation of this industry more and 
more widely; and doubtless we have not yet seen the end of 
its development. 

Thus far we have had in mind only insurance against 
direct loss, for example, fire insurance, cyclone insurance, 
burglar insurance. But the student is aware that very im- 



SPECULATIVE TRADING AND INSURANCE 347 

portant forms of insurance are so-called life and endowment 
insurance. Are these to be explained in the same way? In the 
main, yes. In one respect, however, they obviously differ 
from the cases already considered. The payments made to 
the insured or his family are not intended to cover losses in- 
curred. They rather represent savings, accumulations of cap- 
ital, which he has made or is treated as having made. The 
payments which the insured makes to the officers of the as- 
sociation or company — premiums — consist, in the cases al- 
ready considered, of two parts, (i) a real insurance pre- 
mium, his share of the losses incurred, and (2) his share of 
the costs of carrying on the business. In life or endowment 
insurance, the major part of the payment is different from 
either of these. It is savings deposit, money accumulated and 
placed in the hands of the company as if it were a savings 
bank. The insurance element in his payments is so much as 
is needed to cover the risk that he will not live and pay long 
enough to accumulate the full amount he has set out to pay 
and for which he is insured. The insuring company or asso- 
ciation is concerned with knowing how many payments he is 
likely to make, — which is usually the same as saying how 
many years he will live. Their statistics concern the average 
longevity of men in his class ; the statistics of the companies 
concerned in fire insurance concern the probable number of 
houses of certain types which will burn in a given period. 

Within the memory of people still living, not a few per- 
sons of intelligence and standing were wont to look on insur- 
ance, particularly life insurance, as a form of gambling. What 
has been said ought to convince us of the unsoundness of 
this opinion. Insurance manifestly performs a very real serv- 
ice. It does easily and cheaply something which must he done. 
Risk cannot be eliminated from economic relations. It must 
be borne. Our only freedom of choice concerns the m-ethod 
of bearing it. Insurance is surely the best one yet devised. 

The remarks of the last paragraph suggest the true dis- 
tinction between gambling and legitimate risk-bearing. The 



348 PRINCIPLES OF ECONOMICS 

distinctive mark of gambling is not, as is often fancied, the 
taking of chances, the assumption of risk. Such taking of 
chances is often quite unavoidable, and so, of course, there 
can be nothing wrong about it. The really vital thing about 
gambling is that it assumes risks which are needless. The 
game will be won or lost. Our staking ten dollars upon the 
result is wholly unnecessary and will contribute nothing to 
the determination of the result. If, then, we act in this way, 
we wantonly assume an economic risk which can be avoided 
and the assumption of which is not a condition precedent to 
the accomplishment of any social advantage.* 

IlIvUSTRATIVE PrO'BI^KMS 

1. Suppose i,ooo owners of i,ooo buildings worth each 
$7,000 wish to insure themselves against fire. If the risk for 
the class of buildings involved is such that 7 out of 1,000 burn 
down each year, what annual payment from each owner would 
be necessary to insure all against total loss, — expenses of man- 
agement, interest, etc., being ignored? 

2. Suppose 1,000 persons propose each to save for his 
family before his death, $2,000. All are twenty-five years of 
age. Knowing that anyone is liable to die before he has had 
time to save so much, they combine to insure one another that 
$2,000 shall be ready for the family even if death comes be- 
fore that sum has been regularly accumulated. Assuming that 
the organization is continuous, new members joining as old 
ones pass away, and, assuming the average death rate -to be 
18 in 1,000, what annual payment would each one need to 
make, — expenses of management, interest, etc., being ignored? 

3. Suppose that a certain corporation owns 500 build- 
ings worth each $100,000; that to insure in an ordinary com- 

* In one notable case, the spirit and even the practice of gam- 
bling has not been kept out of connection with legitimate insurance. 
This is the great Marine Insurance Association known as Lloyds of 
London. Here men are able to put up bets on any conceivable event 
without any admixture of necessity or social gain to make it a legiti- 
mate economic operation. 



SPECULATIVE TRADING AND INSURANCE 349 

pany would cost the corporation $250 a year on each build- 
ing; and that the corporation is convinced that by the expen- 
diture of $10,000 the fire loss can be reduced to an average of 
one building every three years. Under these conditions, would 
it pay the corporation to insure with some company? Prove. 



CHAPTER XXII 

PRINCIPLES GOVERNING THE MONEY STANDARD 

The preceding chapter brought to a conclusion our dis- 
cussion of that broad division of Economics known as Ex- 
change. Before finally dismissing this subject, however, we 
shall find it useful to give some further attention to the study 
of Money. Money, as we know, is the medium of exchange; 
and as preliminary to the treatment of exchange, we set forth 
in Chapter XII some of the more simple and obvious truths 
concerning Money. But now, with a thorough study of Ex- 
change as a whole behind us, it becomes possible, as also nec- 
essary and proper, to make a deeper investigation of the me- 
dium by which it is conducted, and to present the more essen- 
tial principles governing that medium. In this chapter we 
take up the principles governing the money standard. 

The monetary standard, the student will remember, is 
that something which fixes the significance or value of the 
money unit. Thus in the United States, 25.8 grains of gold, 
nine-tenths fine, fixes the value of the dollar; — whatever val- 
ue may at any time attach to 25.8 grains of gold, that same 
value will attach to one dollar. Now this very definition 
shows that the monetary standard is, in an important sense, 
the foundation of the whole system, and that a change from 
one standard to another, or even mere liability to change, may 
carry with it the threat of serious harm. Further, experience 
has shown that it is by no means an easy task to insure that 
such changes will not take place. The monetary standard has 
many times been displaced in spite of the utmost preventive 
efforts a government could make ; and, in fact, governments 
themselves have more than once through mistaken legislation 
inadvertently brought about the very displacement which they 



THE MONEY STANDARD 351 

were trying to avoid. Manifestly, then, it is quite important 
that we should know the natural laws which concern the mon- 
etary standard in order that we may be able rightly to manage 
that standard. 

These principles may be grouped in two classes : ( i ) those 
concerned with the immediate standard, standard money, 
which directly, immediately, fixes the value of the money unit, 
and (2) those concerned with the ultimate standard or the 
something which fixes the value of standard money itself, and, 
in doing so, finally fixes the value of the money unit.* 

The first principle to be laid down with respect to stand- 
ard money is the following: 

Principle I. The standard money of any system must 
he a money which is at par and which has its value fixed in- 
dependently of its relations to other moneys. 

The proposition that standard money must be a money 
which is at par is hardly more than a corollary from the defi- 
nition of standard money. Standard money is the immediate 
standard of the system, the money which immediately deter- 
mines what the money unit is worth. To it, the money unit 
is anchored. Its value is the value given to the unit. But, 
plainly, we cannot say of a given money that it fixes the value 
of the money unit unless a unit of that money has the same 
value as the money unit it is said to fix. Thus we cannot re- 
gard gold coin as the standard money of the United States if 
we find that ten-dollar gold pieces are worth eleven dollars 
each; for, in that situation, some other money worth ten- 
elevenths as much as gold must really be fixing the value of 
one dollar. No money which has a value above or below the 
value of the unit can be fixing the value of that unit. 

We have just seen that the standard money must be one 
which is at par. But we commonly find two or more moneys 



* See pages 147, i^ 



352 



PRINCIPLES OP ECONOMICS 



fulfilling this condition, — and which one of the moneys at par 
will then be standard? This question is answered by the sec- 
ond part of our principle. The standard money is that one 
of the par moneys which has its value fixed independently of 
the other moneys. In most cases the soundness of this con- 
tention is evident enough. Thus, in our system, gold coin is 
firmly anchored to the metal contained in it, — has its value 
fixed by that metal quite without regard to the values of the 
other moneys. On the other hand, the values of treasury 
notes, bank notes, and small silver have no sort of relation to 
the value of the material in them, but are all the time kept 
equal to that of gold coin by being kept all the time directly or 
indirectly exchangeable for gold coin. Manifestly, then, as be- 
tween gold coin and the other moneys named, the former is 
the standard : it is the thing which determines; they are things 
which are determined. 

The case of a par money which is not kept either directly 
or indirectly convertible with gold coin is not so plain ; but the 
conclusion must be the same. Such a case is illustrated in 
most countries by small silver which is not redeemable,* and, 
in this country, by silver dollars. No institution is bound to 
redeem these coins in gold or its equivalent.! Further, the 
metal in the coins is much less valuable than gold coin, and is 
changing in value every day. Yet all the time these silver 
coins remain just equal in value to gold coin. Just why they 
do so is a problem with which we are not here concerned. 
Here we are asking : Which of these two is standard money ? 
Which is principal and which subordinate? Which deter- 
mines and which is determined? Surely there can be but one 
answer. The gold coin is fixed in its position, being anchored 
to the metal it contains, while the silver coin, showing no 



*It is redeemable in this country. 

tThe United States Treasury would probably undertake to do so, 
if they became less valuable than gold. 



THB MONEY STANDARD 3^^ 

constant relation to the metal in it, is free to move. Hence, 
unless their equality of value is to be attributed to mere coin- 
cidence, and surely this is out of the question, we must con- 
clude that the value of the silver coin adjusts itself to that of 
the gold coin, — is determined by that of the gold coin. Gold 
coin, therefore, the money which has its value independently 
determined, is the standard money. 

IlIvUSTrative: Probi,e;ms 

1. In the United States in 1870, gold coin was worth 
$1.21 per dollar, silver coin $1.23 per dollar, and greenbacks 
$1.00 per dollar. Which, if any, must have been standard 
money ? 

2. For several weeks during the panic of 1837 coined 
money, whether silver or gold, was at a premium of from 2 to 
4 per cent, while bank notes were at par. Which, if any, must 
have been standard money? 

3. Add to the first problem that in 1870 national bank 
notes were worth $1.00 per dollar and were redeemable in 
greenbacks. Which money, under this condition, must have 
been standard money? 

4. Supposing that all kinds of money are at a premium, 
only bank credit in the form of checks being at par, what then 
would be standard money or the immediate standard ? 

Our first principle has given us little more than a rule for 
recognizing standard money, for ascertaining which money 
is the standard. The second gives us one of the most impor- 
tant laws determining the standard, deciding what money the 
standard must be. 

Principle II. If, among those moneys in any system 
•which are a valid tender in the payment of debts, differences 
of exchange value arise, the cheapest of such valid tender 
moneys establishes itself as the standard money, and the rest 
go to a premium. 



354 PRINCIPLES OF ECONOMICS 

A good illustration of this principle is found in the mone- 
tary history of 1870. At that time paper money, gold coin, 
and silver coin showed differences in value, measured in pa- 
per, as follows: Gold was worth 21 cents more than paper, 
and silver was worth 2 cents more than gold. These differ- 
ences could have manifested themselves in any one of at least 
three ways: (i) paper might have been quoted at $1, gold at 
$1.21, and silver at $1.23, or (2) gold might have been quoted 
at $1, silver at $1.02, and paper at $.82; or (3) silver might 
have been quoted at $1, gold at $.98 and paper at $.81. If the 
first hypothesis had been realized, it can be seen by reference 
to Principle I that paper would have been the standard ; if, in- 
stead, the second hypothesis had been realized, gold would 
have been the standard ; finally, if the third hypothesis, sil- 
ver would have been the standard. In fact, the first hypothe- 
sis was reahzed ; and the natural law which insured that it 
would be is the one stated in our second principle. The cheap- 
est of these legal tenders was bound to establish itself against 
the rest. 

The proof of this principle is relatively simple. By hy- 
pothesis all the moneys in question are valid tenders for debts. 
Under that condition which will be the standard money for 
debts? If I have a right to pay my debts with either of two 
moneys one of which is worth three cents more than the other, 
which will I naturally choose? The cheaper, of course. And 
what I would naturally do, experience proves that debtors 
generally do. It follows then that the cheapest of two or more 
valid tenders will be the standard money of debts. 

Secondly, for the sake of convenience in business transac- 
tions the standard money of debts and that of prices must, if 
possible, be the same. One can imagine the inexpediency of 
having in business one meaning for the dollar in debts, and 
another for the dollar in prices. A grocer fixing the prices of 
his goods in one kind of dollar, while his note to the jobber 
was in another sort of dollar, would meet serious inconven- 



THE MONEY STANDARD 355 

iences ; so he surely would not conduct business in this way 
unless obliged to. But, thirdly, he will not be obliged to do 
this, because the standard money for debts and the standard 
money for prices naturally draw together and become one. 
The standard money of debts is fixed by natural law as the 
cheapest of all the valid tenders, and this result men cannot 
change, save under very exceptional circumstances. But the 
standard money of prices, on the other hand, is determined 
wholly by the choice of the individual dealer. He may freely 
rate his goods in gold dollars or silver dollars, or greenback 
dollars, or even pounds or marks if he desires. It is according- 
ly possible for the standard money of prices to adjust itself to 
the standard money of debts ; and since, as we have already 
seen, such an adjustment is for business reasons highly desira- 
ble, it will inevitably be brought about. In a word, the cheap- 
est of the valid tenders becomes not only the standard for 
debts but also the standard for prices — the standard money in 
general. 

Three special applications of the principle just established 
give us three corollaries of that principle which have played 
a part of very great importance in the monetary history of 
modern times. Those corollaries are as follows: 

Corollary i. // two metallic moneys are freely coined 
and full legal tender at a coinage ratio different from the mar- 
ket ratio, the money coined from the overrated metal mill es- 
tablish itself as the standard money. 

Corollary 2. //, in the case of a legal tender circulating 
note zvhich has hitherto been kept redeemable in what has 
hitherto been standard money, a suspension of payments takes 
place, such legal tender note will almost certainly establish it- 
self as standard money. 

Corollary 3. // any form of credit money or money sub- 
stitute ceases to be redeemable in standard money or its equiv- 



356 PRINCIPIBS OF ECONOMICS 

alent, and^ though not a true legal tender, is made in effect a 
valid tender in payment of debts by any set of circumstances, 
such money or money substitute will for the time being usurp 
the place of standard money. 

To illustrate the first of these corollaries, suppose that, 
when I ounce of gold is worth on the market i6 ounces of sil- 
ver, the government mint treats i ounce of gold as worth only 
15 ounces of silver, putting into each silver coin less metal 
than is needed, considering the market value of the two met- 
als. The mint thus treats silver as worth more than it really 
is ; in technical language, it overrates silver. Under these con- 
ditions, each silver coin will be worth less — it will be cheaper 
money — than the corresponding gold coin. Hence it follows 
from Principle II that the silver coin will assume the place of 
standard money. 

The second corollary, relating to the behavior of legal ten- 
der circulating notes, offers no serious difficulty. So long as 
such notes are kept redeemable in standard money, they of 
course will be worth as much as standard money. When, 
however, the issuer of the notes suspends payment on them, 
their value inevitably declines, because, although people may 
expect them to be again made redeemable at some future time, 
they are not willing to give as much for a probable future pay- 
ment as for a certain present one. But when notes with the 
faculty of legal tender become less valuable than the money 
which has hitherto been standard money, this fact brings into 
operation Principle II, — that is, these notes displace the money 
hitherto standard, and themselves usurp its office. 

The circumstance alluded to in the third corollary has re- 
peatedly arisen in our history when a concerted suspension of 
payment on their notes by practically all banks has led the gen- 
eral public by tacit consent to treat those notes as a valid ten- 
der for debts. As a result, the notes behaved as if they were 
a true legal tender: in other words. Corollary 2 was brought 
into operation. 



THE MONEY STANDARD 357 

In a similar way, bank credit, deposit currency, as it is 
often called, has more than once been made the standard mon- 
ey by a concerted refusal of banks to pay in any form of mon- 
ey. At such times, the public has come to accept bank credit 
as a valid tender for debts, thus making bank credit the imme- 
diate standard, while all forms of money proper went to a pre- 
mium. 

IivivUSTRATivE Problems 

1. In the United States in 1830, both gold and silver were 
freely coined at a ratio of 15 to i, when the market ratio was 
15.8 to I. 

(a) Which metal did the mint overrate? Explain care- 
fully. 

(b) Which of the two moneys, if any, must have been 
standard money? 

2. In 1830 France had a system similar to ours but its 
ratio was 15.5 to i. 

Answer the same questions for it, as for the United States 
under i. 

3. Why did the United States have the greenback as its 
standard money between 1862 and 1879? 

4. In 1717 the British government decreed that a gold 
guinea should be treated as the equivalent of 21 silver shill- 
ings ; though, judged by the bullion in them, the guinea was 
worth 20^ shillings. Which must have become standard 
money ? Explain. 

4. In 1 71 7 the British government decreed that a gold 
guinea should be treated as the equivalent of 21 silver shill- 
ings; though, judged by the bullion in them, the guinea was 
worth 20^ shillings. Which must have become standard 
money? Explain. 

In the panic weeks of 1837, bank notes were the stand- 
ard money. (See Problem 2, page 353.) How do you ex- 
plain it? 

Thus far our discussion has been concerned with standard 
money and the laws governing it. Two other principles of 
considerable importance have to do with defining and deter- 



358 PRINCIPLES OP ECONOMICS 

mining the ultimate standard. The first of these is the follow- 
ing: 

Principle III. // by any process zvhatsoever the stand- 
ard money is kept constantly equal in value to a definite quan- 
tity of some outside commodity or group of commodities, 
such commodity or group of commodities constitutes the ulti- 
mate standard of the system. 

This principle can perhaps be best illustrated by imagining 
a system in which there was no metallic money, some kind of 
paper money being the standard money, but in which that pa- 
per money was all the time kept equal in value to a certain 
amount of gold or silver or some other outside substance. In 
such a system, the principle tells us, the gold or silver or other 
outside substance to which the standard money was kept equal 
in value would constitute the ultimate standard. 

As a matter of fact, this particular method of realizing the 
condition indicated in our principle is not actually employed, 
though some very able economists have favored it. The plan 
generally pursued is to have, as our standard money, coins 
made of the very metal which we wish to use for our stand- 
ard, in our own case, gold. These coins we keep equal in 
value to the quantity of gold (25.8 grains) desired for our ul- 
timate standard by maintaining two conditions which insure 
this result: (i) the metal gold has free and gratuitous coin- 
age — the mint must turn into coin of full weight without sub- 
stantial charge whatever gold is offered; and (2) under ordi- 
nary conditions, free melting of gold coin is permitted. When 
these conditions are realized, it is plainly impossible that the 
coin and the metal, being practically interconvertible, should 
have different values. No one would give more for the coin 
than for the metal, since he could have that metal turned into 
coin without charge ; so he would not give more for the metal 
than for the coin, since he could at will turn the coin into the 
metal by melting it. 



THE MONEY STANDARD 359 

In the above illustration of our principle, we supposed that 
a certain amount of gold was chosen as the ultimate standard. 
But, of course, some other metal, for example silver, may be 
chosen, or something not a metal, say, wheat, or a group of 
things made up of many items : a ton of coal plus 10 yards 
of cotton plus 100 pounds of flour, etc., etc. A standard of 
the latter sort has been advocated by many able men and is 
commonly known as a multiple standard. But, whatever the 
particular thing or things chosen, the idea is the same : if there 
is something outside the standard money which fixes the value 
of that standard money, that something is the ultimate stand- 
ard. 

The principle needs little argument to establish its truth, 
since it is little more than a corollary from the definition of the 
ultimate standard. The ultimate standard is the something 
behind the immediate standard, standard money, which finally 
determines the value of that money, just as that standard mon- 
ey determines the value of the money unit. Now, it can hardly 
be doubted that the gold or silver or wheat or list of goods 
used in our illustrations answers to this definition of the ulti- 
mate standard. First, by hypothesis, the standard money is 
kept equal to such gold or silver or wheat ; and so, the latter 
is, in some sense, standard. Secondly, since this gold or sil- 
ver or wheat is not, in turn, dependent on something else for 
its value, such gold or silver or wheat constitutes the final, ul- 
timate, standard. 

Perhaps a doubt may still linger in the student's mind. "It 
is plain that the value of our standard money, gold coin, and 
the value of the gold metal in that coin are equal. But are 
we sure that the value of the metal fixes the value of the coin 
rather than the reverse? Surely, gold as a metal has its value 
influenced by the value of the gold money." The last state- 
ment is no doubt correct : the value of the money influences that 
of the metal just as truly as the value of the metal influences 
that of the money. Nevertheless, one of these, the metal, must 



36o rRINClPLBS OF ECONOMICS 

be looked on as, in the more ultimate sense, a determinant. The 
gold coin of any one country constitutes only a small frac- 
tion of the total gold coin of the world, and a still smaller 
fraction of the total gold metal — coin, articles made of gold 
and gold bullion. Conditions tending to bring about a change in 
the money of a particular country independently of the gold 
stock of the world must, of course, tend to exercise some in- 
fluence on the value of that gold stock. But, after all, the 
small fraction cannot be credited with determining the value 
of the whole. The total gold stock must have a value resulting 
from the action of numberless other forces as well as the 
causes which influence the value of the money of a single 
country; and, to the value of the total gold stock as thus de- 
termined, the value of the gold coin of any particular country 
must tend to gravitate. As long as the money unit of a coun- 
try is kept equal in value to a certain quantity of the metal 
gold, that metal must be recognized as the truly ultimate stand- 
ard. 

Ili^ustrative Problems 

1. A few years ago, the United States remodeled the 
monetary system of the Philippines, making silver pesos coined 
only for the government the standard money, but provid- 
ing that gold exchange on New York should be sold to any 
person wanting it in exchange for silver pesos at a rate of $i 
for two pesos. Such a system tended to estabhsh what ulti- 
mate money standard in the Philippines? 

2. Great Britain puts into every sovereign 113 grains of 
pure gold, coins these sovereigns for every one free of charge, 
and does not attempt to hinder the melting of coins. Under 
these conditions what necessarily becomes the ultimate stand- 
ard of Great Britain? Explain fully. 

3. What must have been the ultimate standard of the 
United States in 1830? See Problem i, page 357. 

4. What must have been the ultimate standard of France 
at the same date? See Problem 2, same page. 



THE MONEY STANDARD 361 

Our second principle with respect to the ultimate standard 
has to do with a situation where the standard money is itself 
the ultimate standard. Prior to 1893 British India had as its 
ultimate money standard 180 grains of silver; that is, the unit 
coin, the rupee, contained 180 grains of silver and was freely 
coined, thus making the metal itself the ultimate determinant 
of the value of the rupee. But, in the year named, the gov- 
ernment stopped the free coinage of silver with the result that 
coins rose in value as compared with the metal in them, fluc- 
tuating from 32 cents down towards, but never to, their bul- 
lion value, 22 cents. Thus the silver rupee had nothing be- 
hind it to fix its value — it moved up and down independently of 
anything else. Accordingly, the silver rupee fixed the value of 
the unit (the rupee) not only immediately hut also ultimately ; 
and hence was itself the ultimate standard. This illustration 
alone would seem to furnish sufficient proof of the following 
principle : 

Principle IV. // the standard money is not kept constantly 
equal in value to a fixed quantity of some commodity or group 
of commodities outside itself, but varies in value independently 
of the variations of any other object, then such standard 
money is itself the ultimate standard of the system. 

IlvLUSTRATlVK PROiBLi;MS 

1. What was the ultimate standard of the United States 
between 1862 and 1879? Explain. 

2. What was the ultimate standard of the United States 
during the panic weeks of 1837. See problem 2, page 353. 

3. Suppose that after 1893 the government of British 
India had so managed things as to keep gold exchange on 
London constantly at 20 rupees for i sovereign ( 123.27 grains 
of gold). What would then have been practically the ultimate 
standard of India? 



CHAPTER XXIII 

PRINCIPLES GOVERNING THE CIRCULATION 
OF MONEY 

The second group of principles under our present subject 
concern the circulation of money — the capacity of money to 
form a part of the monetary stock, the active medium of ex- 
change. Will a particular money circulate at all ? What kinds 
of money have the greater capacity for circulating — the great- 
er tenacity in circulation? To what part of the circulation 
is a particular kind of money likely to gravitate? Will it tend 
to be used in the ordinary business of exchanging commodities 
or will it more probably lie most of the time in the banks serv- 
ing the purpose of a reserve fund? 

These and other related questions are of importance because 
a government may in one case find it desirable to keep a 
particular money in circulation; or in another case to drive 
a particular money out of circulation; or in still another to 
keep a particular kind of money down to a small stock, though 
not driving it out altogether ; or again to segregate a particular 
kind of m_oney in some special part of the system. A govern- 
ment may, I say, at some time desire to do any of these things ; 
but it can no more accomplish its desire by merely decreeing 
such a result than it can bridge a river by that process. The 
circulation of money is ruled by natural laws ; and a govern- 
ment can accomplish its objects in that field only by establish- 
ing such conditions that the natural laws which rule the cir- 
culation will automatically work out the results desired. It is 
of prime importance, therefore, that we should be familiar 
with the more influential of these natural laws. 



THE CIRCULATION OP MONEY 363 

The first principle which we shall lay dow^n runs as fol- 
lows: 

Principle I. Under modern conditions, the full and con- 
tinuous circidation of any kind of money in almost any coun- 
try of high commercial development requires a measure of 
legal authorisation from the government of that country. 

The most decisive proof of this principle is to be found in 
the fact that, in all but very exceptional cases, the circulation 
of a money is Hmited to the country where it is legally au- 
thorized. Even nations lying geographically side by side, close- 
ly connected in industry and commerce and using the same 
monetary standard and the same system of denominations, — 
even such nations do not usually circulate each other's money 
save along the border. Thus, despite the proximity and the in- 
timate relations of Canada and the United States, Canadian 
money has no currency in this country outside Detroit, Buffalo, 
and a few other similarly situated places. 

This connection between the circulation of a money and its 
legal authorization by the home government is, of course, no 
mere accident. From early times governments have been wont 
to issue the money of their respective countries; so that now, 
habit, if nothing more, would make the public chary of ac- 
cepting any medium of exchange not authorized by govern- 
ment. Further, authorization by a government creates a pre- 
sumption that tfeat government will make some effort to insure 
the goodness of the money authorized. Such moneys, there- 
fore, will naturally be more readily accepted in ordinary 
transactions than money which has nothing but private back- 
ing. Again, as between a money authorized by one's own 
government and one authorized by the government of some 
other country, men will naturally have more confidence in that 
authorized by their own. Finally, the government itself will 
usually discriminate against foreign moneys in certain rela- 
tions, for example, in determining what shall be receiv- 



364 PRINCIPLES OF ECONOMICS 

able for public dues or what shall be a legal tender for debts. 
This public discrimination will exercise more or less compul- 
sion on private persons to take a similar attitude. 

We have seen that the power of a money to circulate usu- 
ally depends on some degree of governmental recognition. 
Our next principle puts this case somewhat more strongly. 

Principle II. Under modern conditions, the power of any 
money to hold its place in the circulation in the fullest sense 
varies cw* the extent to whicJidt is given power to do the differ- 
ent kinds of money work. 

Thus, a money which will not be accepted by the govern- 
ment in payment of taxes or which cannot be used as bank re- 
serves will have less tenacity in circulation than a money which 
enjoys these prerogatives. In part, evidently, the capacity of a 
money to circulate depends upon the willingness of people to 
accept it in return for commodities and services. But some per- 
sons, anyhow, will need to use a part of the money, received 
in exchange for their goods, for the purposes indicated, — to 
pay taxes and maintain reserves. They will, therefore, hesitate 
to accept, or perhaps absolutely refuse to accept, money which 
cannot be utilized for these purposes. Further, if the money 
is one which they are not really free to reject in trade, they 
may yet be free, as in the case of the circulating notes of a 
bank, to return it to the issuer, getting in exchange some money 
which possesses the prerogatives lacking in the one in question. 
This course they are likely to take, and, in so doing, they put 
such money out of circulation. 

An obvious inference from the principle is that, if we wish 
to diminish the tenacity in circulation of any money, we can 



*Remember that in Economics "to vary directly as" means only to 
vary in the same direction, not proportionately, and to "vary inversely 
as" means only to vary in the opposite direction, not proportionately. 



THE CIRCULATION OF MONEY 365 

usually do so by depriving it of some prerogative;* — refusing 
to receive it for taxes, forbidding its use as bank reserves, or 
prohibiting bankers who receive it from paying it out over the 
counter. 

The two principles just set forth affirm that moneys of su- 
perior quality — those having recognition by the government 
and possessing all money prerogatives — remain more persist- 
ently in circulation than inferior moneys. We have now to re- 
mark on a principle which seems almost in fiat contradiction 
of these. It affirms that inferior moneys have greater power in 
circulation. The formula "bad money drives out good", com- 
monly known as Gresham's Law, is the one most in vogue. As 
thus stated, the doctrine was always inexact; and, however 
stated, it is now true to a much smaller degree than in earlier 
times. Perhaps the facts are fairly well covered in the follow- 
ing: 

Principle III, Moneys which are inferior in respect to 
exchange or substance value commonly show greater tenacity 
in circulation than those which are superior in these respects. 

The truth of this principle has been amply confirmed in 
monetary history, — in fact, the principle is one of the few in 
economic science which have been accepted primarily as in- 
ductions from experience. Its explanation is easily found in 
the causes at work. The chief of these causes is the fact that, 
in the circulation proper — the use of money in actual exchange 
transactions — the superiority or inferiority of different kinds 
of moneys shows relatively little ; whereas in various other 
uses, less strictly belonging to the circulation proper, or even 
quite outside the field of money, the superiority or inferiority 
shows relatively much. 

Take first the case of standard metallic money, — gold coin 
in our system. Coins short in weight have no difficulty passing 



*This must be qualified by a consideration of the principle aoout 
to be commented upon. 



366 PRINCIPLES OP ECONOMICS 

in trade. Only a careful test would prove that they are actu- 
ally short; and this test few people in the hurry of business 
care to make. Further, most people assume that, even if a coin 
is really short, no trouble will be experienced in passing it on 
to someone else. In active circulation, then, inferior coins 
serve as well as any. But not so in other relations. If a jewel- 
er wishes to melt a gold coin to get the metal for use in his 
trade, he naturally chooses a ten dollar piece of full weight, 
258 grains, rather than one weighing somewhat less, say, 240 
grains. The same is of course true of the exchange dealer who 
has occasion to send gold abroad in covering his drafts. Again, 
the peculiar position of the banker strengthens in another way 
the tendency of short weight coins to stay in circulation. Gov- 
ernments and other institutions to which the banker makes 
payments will discriminate against inferior coins, so that, to 
save himself a loss, he must refuse to receive them except at 
a discount. But depositors, in turn, anxious to escape this 
discount, studiously avoid presenting such coins for deposit, — - 
instead, keeping them for their own use in trade, while they 
take to the bank full weight coin or other par money. 

The illustration just used concerns standard metallic 
moneys which show differences in substance value as well as 
in exchange value. But paper moneys, which differ in ex- 
change value only, submit easily to the same principle. Thus, 
prior to 1863, the bank notes of this country issued by all sorts 
of institutions and under all sorts of conditions, circulated at 
different values measured in standard money, some worth 
100 cents on the dollar, some worth 95, some 92, some 97. Of 
these notes the best ones usually showed less capacity to hold 
their place in the circulation than the inferior ones. Their 
acceptability in ordinary trade was not, indeed, as good as that 
of gold coin which was only a little inferior in weight. But, 
assisted by the ignorance of people in general, by the indisposi- 
tion of tradesmen to displease customers by challenging money 
offered for goods, and by the anxiety of workingmen to keep 
their jobs, anyone who held such money could easily pass it 



THB CIRCULATION OP MONBY 367 

on at a value greater than that recognized by banks and other 
dealers in exchange. 

On the other hand, the inferior notes were received at 
banks and pubHc institutions only at a full discount. Accord- 
ingly, they were not taken in for deposit, but were sorted out 
for use in trade, while notes of the better grades went in. 
Further, the institutions in question, desiring to make room for 
their own notes, and to accumulate only moneys which would 
be useful as reserves, made a practice of sending home for 
redemption all the foreign notes they received ; hence, the 
fact that the ones they received were chiefly the better ones, 
resulted directly in driving these better ones out of circula- 
tion. Thus, there were at work not only forces tending to 
choose the inferior moneys for the circulation proper, but also 
forces tending positively to drive the superior out. 

It perhaps ought to be added that, even when the inferiority 
or superiority among moneys, is not openly recognized, though 
admitted by the initiated, the inferior is likely to show a 
stronger hold on the circulation. Banking institutions being, as 
we have seen, in a position to discriminate, by paying over the 
counter the less desirable forms of money and retaining for 
reserves the more desirable, can and do keep the former in 
more active circulation. 

The points made in the foregoing discussion apply in large 
measure to all kinds of money. The considerations now to 
be brought forward concern only credit money. Credit money, 
for example, a bank note, is simply a promise of the issuer 
to pay upon demand a stated sum of standard money or its 
equivalent ; and such money is, by return to the issuer, retired 
from circulation. Accordingly, the degree to which such a 
money is able to maintain its hold on the circulation depends 
on the strength of the tendency to send it home. This in turn, 
depends chiefly on two conditions: (i) the strength of the 
motive for returning it, and (2) the ease with which the opera- 
tion can be carried out. As respects the first, if a bank note 
or other credit money is qualified to perform all the functions 



368 PRINCIPLES OP ECONOMICS 

which the standard money that it calls for can perform, there 
will be little, if any, reason for sending it home. If, however, 
it is not receivable for public dues or is not a legal tender for 
ordinary debts, there will be some holders, anyhow, who have 
am.ple motive for sending it in to be exchanged for money 
more adequate for their purposes. 

The working of the second condition on which depends the 
strength of the tendency to send credit money home — the ease 
with which the operation can be carried out — may be seen 
from an imaginary illustration. If a note holder lives in 
Boston while the issuing bank is located in Butte, Montana, 
and the noteholder has no way of securing redemption except 
by sending the note from Boston to Butte and bringing back 
the money at his own expense, there will probably be little of 
such sending undertaken. In such case, even though the note 
is not usable for the payment of taxes, the holder will con- 
tent himself with retaining it for use in ordinary business. 
Thus, such notes tend to continue in circulation rather than 
go out by return to the issuer. They have tenacity in circula- 
tion just because there is difficulty in sending them home. 

Although the conclusion just reached was based merely on 
a consideration of the causes at work, its soundness has been 
fully confirmed in the history of bank note issues. Thus, in 
the United States in the early part of the last century, when the 
provisions for securing the "homing" of notes were quite 
inadequate, those notes which could be returned only at con- 
siderable trouble and expense almost completely monopolized 
the circulation as against notes which could easily be returned. 
This was conspicuously illustrated in the city of Boston 
as between the notes of outlying towns and those of Boston 
itself,— the latter being largely driven out by the former. 
The condition was remedied by providing for the redemption 
at par in Boston of the outside notes, and establishing an ar- 
rangement whereby the institution which performed this task 
became in eft'ect a clearing-house for these notes. 



THE CIRCULATION OF MONEY 



369 



Under the complicated conditions of modern business, the 
money stock of a country naturally distributes itself, or is con- 
sciously distributed, into different parts called funds, each of 
which has a special function. Thus, a very considerable part 
of the stock is used as a medium of exchange in ordinary busi- 
ness. A second large quantity constitutes the reserves of the 
banks, especially those outside of New York City. The New 
York bank reserves constitute a third fund, distinct from ordin- 
ary bank reserves because, for reasons too complicated for 
review in this place, the general banking reserves of the country 
largely rest upon it. This fund also requires differentiation 
because it is the chief source from which must come the money 
employed in the settling of international balances. Another 
very significant fund is the 150 millions of gold reserved by 
law in the Federal Treasury for the redemption of treasury 
notes. Under the Federal Reserve system adopted a few years 
ago, the reserves of the so-called regional banks ought perhaps 
to be treated as constituting still another special fund. 

Now, it is a matter of some consequence that the proper 
sort of money and that sort only should find its way into 
each particular fund; and the government takes pains so to 
manage the issue of different kinds of money that, as far as 
possible, proper distribution will be automatically effected. 
The result is largely brought about by issuing just the right 
denominations of the money which is meattt for a given fund 
and for the appointed uses of that fund. Thus, if it is de- 
sired to keep a certain type of money out of banking reserves, 
especially out of the New York reserve, this is accomplished by 
putting out the money in small denominations. The principle 
which furnishes the basis for such a policy may be stated as 
follows : 

Principle IV. In the distribution of the monetary stock 
of a cou.ntry, money of smaller denominations naturally gravi- 
tates to the Circidatlon Proper, the part tvhich is being used 



370 PRINCIPLBS OF ECONOMICS 

directly as a medium of exchange; moneys of larger denomina- 
tions gravitate to the Reserves, the funds kept by banks and 
other institutions to meet credit obligations. 

This principle has been utiHzed in the practical manage- 
ment of our silver certificates, and so may be said to have been 
established inductively. But it naturally results from the con- 
ditions and forces present. There is comparatively little need 
for money of large denominations in ordinary transactions, 
since persons engaged in those transactions usually pay by 
means of checks. If, then, we restrict the issue of any kind 
of money to large denominations, we are certain to keep the 
greater part of it out of the ordinary circulation. On the 
other hand, in the ordinary transactions of the market there 
is much need for small money, whether in effecting payments 
outright or in making change. In consequence, we can easily 
infer that money of very small denominations will remain in 
ordinary circulation and will stay out of the bank reserves, un- 
less it is issued in greatly excessive amounts. As a matter of 
fact, experience shows that it is extremely difficult to satisfy 
the every day need for money of small denominations. The 
government of the United States has been obliged over and over 
again to expand its issue of fractional silver and of small bills 
from $1 to $5. 

Illustrative Problems 

1. In 1849, when the United States had free coinage of 
both gold and silver, a change in the relative values of the two 
metals sent silver coin to a premium, i.e., two silver half-dollars 
were worth $1.02. What naturally happened to silver coin? 

2. During the Civil War, the government of the United 
States thought best to borrow money by paying soldiers, con- 
tractors, et ah, with treasury notes. Yet it was desirous that 
these notes should not be added to the circulating medium, but 
should soon get into the hands of people who would lay them 
one side and hold them till they were due, — in other words, 
treat them as bonds. The Treasury finally hit on a pretty good 
plan to accomplish this, namely, the issuing of these notes to 



THE CIRCULATION OF MONEY 



371 



bear interest, that interest to be compounded every six months 
but to be paid only at the end of three years. How would this 
plan tend to accomplish the end sought ? 

3. In 1862, when gold payment on treasury notes had al- 
ready been suspended, the United States began the issue of 
legal tender notes. In consequence gold went to a premium, 
soon being worth $1.15 per dollar. What naturally happened 
to it? 

4. Experts consider it very desirable that the bank note 
circulation should be elastic, — should expand readily when the 
need for money increases and contract promptly when the 
need diminishes. Of these two phases of elasticity, the second 
is in a sense the more important, in that it really provides 
for the first. In order to secure this power of prompt contrac- 
tion, various provisions have been enacted or proposed; (a) 
establish a good many redemption agencies at convenient points 
throughout the country; (b) prohibit any bank from paying 
out in regular business the notes of another bank except in the 
city or district where the issuing bank is located; (c) pro- 
hibit the use of bank notes as reserves by banks outside the 
system; (d) take away the right of legal tender to government; 
and so on. 

Explain in each case why the provision set forth would nat- 
urally contribute to the contractility of the note circulation. 

5. In 1894, on account of excessive issue of silver and 
paper money, as also on account of the marked decline in busi- 
ness activity, the United States had a great excess of circulating 
medium. This fact (combined, doubtless, with other causes) 
led to a considerable contraction by export to other countries. 
What kind of money must have gone? 

6. In 1886, Congress provided by law for the issue of sil- 
ver certificates of $1, $2, and $5 denominations, and in 1900 
decreed that 90 per cent of the total amount of such certificates 
should be in denominations from $10 down. 'What did they 
hope to accomplish by this legislation ? 



CHAPTER XXIV 

PRINCIPLES GOVERNING THE MOVEMENTS 
AND DISTRIBUTION OF MONEY 

The monetary stock of any country, as also of the world, 
is constantly in motion. Scarcely a day passes without the 
shifting of considerable sums of actual cash between different 
districts of the same country ; and even the movements be- 
tween nations, though by no means so frequent, are in the 
aggregate very extensive. 

For various reasons these movements of money are of 
much interest and significance, both to the specialist and the 
general pubHc. First, every money movement considered by it- 
self tends to change the distribution of the money stock among 
different districts or countries ; and, if for any reason the 
movement in one direction is long enough continued, it may 
cause an excessive supply at one point and a deficient supply 
at other points. As a matter of fact, this result is much less 
likely to occur than people commonly suppose, and even if 
it did occur it would probably be quite harmless. Occasional- 
ly, however, there may be changes of a really undesirable 
character; and so a knowledge of the principles governing 
them is needed as a basis for a corrective poHcy. Moreover, 
it will be decidedly worth our while to have a knowledge of 
even the harmless changes in distribution, lest, in thinking 
them pernicious, we should suffer needless anxiety and make 
ill-advised efforts to modify them. In the second place, there 
are some kinds of money movements which indicate diseased 
conditions in the monetary system, and a knowledge of these 
movements is pretty certain to prove useful when we are try- 
ing to locate the trouble. We shall, therefore, in the present 
chapter, set forth the natural laws regulating movements of 



MOVBMBNTS AND DISTRIBUTION OB MONBY 373 

money between different countries or districts, and regulat- 
ing the territorial distribution of the stock of money which 
results from these movements. 

A notable fallacy in connection with the subject of money 
movements is almost constantly and everywhere current. It 
assumes that buying any goods or services from another coun- 
try naturally means losing some of our stock of money to that 
country. If we give up the production of some commodity 
for which we show comparatively little fatness, and commence 
buying that commodity from our neighbors, people at once 
condemn the trade as certain to draw away a portion of our 
money. They may even fancy that, if we allow perfect free- 
dom of trade, all our money will be drained away. 

This error was fully, though indirectly exposed, under the 
Principle of Reciprocity, so a briefer statement, with a slight- 
ly different emphasis, will serve in the present connection. The 
dealings of one country with another, or, more exactly, of the 
people of one country with those of another, do not in them- 
selves lead to net money movements. Even if the interna- 
tional dealings were commonly effected with money directly, 
there would be few or no net movements, assuming that we 
have in mind intervals of at least a few months in length. The 
reason is plain. No sensible person wants money for the 
money's sake. Our neighbors are anxious to get money by sell- 
ing their products, not because they wish to keep that money, 
but because they wish to use it again to buy our products. This 
fact appears clearly enough within the limits of our own 
town ; and in no essential respect does the trade within a town 
differ from the trade between it and other towns, or from the 
trade between the country as a whole and other countries. 
Money naturally comes back as surely as it goes away. 

Again, under the credit regime which actually prevails in 
inter-local trade, no considerable movements of money ever 
take place except in very unusual circumstances. The recip- 
rocal claims and obligations between the dealers of different 



374 PRINCIPLES OP ECONOMICS 

countries which grow out of their trade deaHngs are trans- 
formed into claims and obligations between the bankers or 
exchange dealers of those countries; and, between these 
bankers, money itself actually flows only when their recipro- 
cal claims fail to balance. Furthermore, this failure to bal- 
ance must be of appreciable duration — a few weeks at least; 
for usually an exchange dealer with an adverse balance will 
as a first resort borrow from his correspondent, sending mon- 
ey only when it becomes evident that the adverse balance will 
not be turned into a favorable one for a long time. 

, What we have thus shown to be true of trade relations, we 
can also show to be true of investment transactions — the lend- 
ing of capital by the people of one place to the people of an- 
other place. Transfers of capital between communities, Hke 
trade payments, primarily take the form of debts between the 
bankers of the different communities. A person in England 
who lends money to an American railroad by purchasing its 
bonds does not send over money to that railroad ; his pay- 
ment, exactly like a payment for wheat or cotton, appears as 
a debt created against some London house and in favor of 
some New York house. It is thus plain that, at the outset 
anyhow, such a shifting of capital does not constitute a move- 
ment of money. 

But, someone may object, would it not necessarily mean a 
movement in the end? For transactions in capital, unlike 
trade transactions, are almost certainly one sided; Europe 
might lend much to America while America lent little to Eu- 
rope, and hence, to balance the claims against them which 
have grown out of buying American bonds, the European 
houses would apparently sooner or later be compelled to send 
money. But even here another alternative is possible. While 
America holds an abundance of claims on Europe and may 
use them to demand money if she likes, she probably will not 
do so, because it is not money that she wants. The borrow- 
ing railroads do not want money, but rails, cars and locomo- 



MOVEMENTS AND DISTRIBUTION OF MONEY 375 

tives. And these articles they wih either buy abroad with 
the borrowed money, or they wih buy abroad some other ar- 
ticles in order to release American capital and labor which 
can produce the rails, etc., at home; in either case, America 
buys from Europe more goods than usual. Thus the debt of 
European exchange houses to American exchange houses aris- 
ing out of the fact that Europe is lending us capital, is likely 
to be matched with a debt of American houses to European 
houses arising out of the fact that Americans have bought 
from Europe more goods than usual. The debts are accord- 
ingly cancelled and no money will flow either way. 

We thus see that neither trade nor investment transactions 
necessarily involve money movements. They may, however, 
involve such movements, if the circumstances happen to be 
of a particular character. Confining our attention for the 
moment to trade relations, let us examine what those circum- 
stances are. Any fact which causes the total volume of 
goods or services bought by any community from other com- 
munities to remain for some time in excess of its sales to those 
other communities, will tend to bring about a net movement 
of money from the community whose purchases are in ex- 
cess ; on the other hand, any fact making the sales of a com- 
munity exceed its purchases, will tend to bring about a net 
movement of money into that community. The argument is 
too simple to need elaboration. The exchange dealers of a 
community which buys more than it sells will for a shorter or 
longer period be in debt to the exchange dealers of other com- 
munities. But the creditor dealers do not like to wait indefi- 
nitely for their pay, and so, if there is no promise of an early 
turning of the tide, they will probably order the money itself 
delivered. This principle is illustrated almost every year in 
the trade between America and Europe. The exports of 
America, being largely agricultural, are naturally "bunched" 
at certain seasons ; while its imports from Europe, being gen- 
erally manufactured products, are distributed more uniformly 



376 PRINCIPLES OP ECONOMICS 

through the year. Consequently, temporary balances against 
Europe are almost sure to appear in the fall season and to 
lead to movements of money toward America. 

There are likewise cdnditions under which investment 
transactions may cause money movements. An exchange bal- 
ance created against a lending country by the movement of 
capital is, as we have seen, usually offset through the natural 
readjustments of trade — the expansion of imports into the 
borrowing country. But if the movement of capital from 
country to country is very large and rapid, the growth of 
trade may not be rapid enough, for an extended period, to 
restore the balance. In this event, the creditor country, un- 
willing to lose the use of its capital, if only for a few weeks, 
will probably order the gold shipped. 

Bringing the essential points of the foregoing discussion 
into a single statement, we have the following principle : 

Principle I. The dealings of one country {community) 
with other countries in respect to goods and capital do not in 
themselves naturally lead to net movements of money either 
to or from said country; hut, if circumstances are such as to 
maintain a balance of claims for or against said country for 
a period of several weeks, a net movement of money to or 
from that country is probable. 

Based upon the above principle are five corollaries, each of 
which should, with only the briefest statement, explain itself. 

Corollary i. Money tends to flow to any country (com- 
munity) where the rate of discount is exceptionally high, and 
vice versa. 

If the rate of discount in any country or community, let 
us say New York, rises to a point two or three per cent high- 
er than in London or Paris, bankers having connections in 
New York will hast en- to avail themselves of this opportunity 
to make exceptional profit by transferring funds to New York. 



MOVEMENTS AND DISTRIBUTION OF MONEY 377 

Naturally, they will so far as possible use credit for this pur- 
pose. But, if the high rate persists and they continue to send 
funds, they will soon exhaust the available supply of credit 
and, thereafter, will send money. 

Corollary 2. Money tends to floiv from a country where 
the stock is abnormally large as indicated by the state of the 
central reserves. 

This corollary is closely related to the last. An excessive 
money stock causes a fall in the rate of discount, which brings 
into operation Corollary i. In extreme cases, an excess of 
money raises the prices of commodities ; this naturally brings 
about an expansion of the import trade; and the latter, by 
creating a balance against the country, finally causes an out- 
flow of money. 

Corollary 3. There tends to be a continuous net flow of 
money from a country which is a producer of standard money 
metal. 

Corollary 3 remarks the tendency of money to flow from 
a country producing standard money metal. The reason for 
an outflow of this kind is not far to seek. The natural and 
easy way to market standard money metal is to take it, di- 
rectly or indirectly, to the mint, have it turned into money, and 
sell it as money — that is, spend it for goods. By this proc- 
ess the money stock of a gold-producing country is constantly 
being augmented, and is constantly becoming excessive ; and 
with an excess of money there come into operation the influ- 
ences already cited under Corollary 2. This proposition needs 
emphasis chiefly because it shows the folly of undue anxiety 
respecting an excess of gold exports from a nation producing 
a large amount of gold. We should expect, as a matter of 
course, that the custom house reports of the United States or 
Australia would show them exporting more gold than they 



378 PRINCIPLES OF ECONOMICS 

import. Gold is one of their important products which they 
naturally use to buy things they cannot produce so easily, just 
as they use wheat or wool. 

Corollary 4. Money tends to How from any country 
which has experienced a marked decline in industrial activity. 

When business slackens there is less money work to be 
done ; this makes the existing money stock excessive, and so 
brings into operation Corollary 2. 

Corollary 5. // a full weight metallic money comes to 
commxind a premiuni, it tends to he exported from the coun- 
try. 

Full weight metallic money which comes to command a 
premium, is certain to be withdrawn from circulation almost 
completely ; since it will seldom be accepted in exchange at as 
high a premium as that given on the bulHon market. But, 
being withdrawn from circulation, it becomes mere bullion, 
a metal, not money. Again, changing such a quantity of money 
into bullion inevitably makes the stock of bullion altogether 
excessive for the uses to which it can now be put. In conse- 
quence, the value of the bullion in the home market is lowered 
as compared with its value in other markets ; to put it a little 
differently, the premium which the bullion bears at home is not 
so great as the difference between its nominal value as money 
and its value in other countries. It will therefore be exported 
to those countries where its value is greater. 

The discussion of Principle I and its corollaries must by 
this time have made it clear that purchase abroad does not 
necessarily mean a loss of money from the purchasing coun- 
try. But, further, if we look more deeply into this subject, we 
shall find that money drains, when they do occur, can in all 
but a few special circumstances safely be left to correction by 
natural causes. 



MOVEMENTS AND DISTRIBUTION OP MONEY 379 

First, the movement may be stopped by the automatic re- 
versal of that condition which is necessary to bring it about. 
That condition is a high rate of exchange, a rate on London, 
for example, of $4.89; for obviously, the exchange dealer 
could not afford to send gold unless he got out of the transac- 
tion the value of a sovereign $4.866-|- plus the cost of send- 
ing it, about three and one-half cents. But such a high rate of 
exchange will naturally set up an unusually strong tendency 
for the export of goods. If I am selling wheat to London, 
when claims against London — which will be used to pay for 
my wheat — are selling at several cents above par, my trade 
will be unusually profitable. I will therefore be eager to sell 
as much as possible ; but so will other American exporters be 
eager to sell, and, competing against each other, we will shade 
our prices ; with prices lowered, our eagerness to sell will be 
met with eagerness of Londoners to buy, — so that our ex- 
port of goods will increase at a bound. But what, now, will 
be the consequence of the increase in exports due to the high 
price of exchange? Manifestly, those exports will put Lon- 
doners in debt to us, will increase the supply of claims, or ex- 
change, on London. But when exchange becomes abundant, 
its price will inevitably be lowered. And, finally, since, as we 
saw at the outset, a high rate is necessary if gold is to be ex- 
ported, the lowered rate will tend to check the export. To put 
the whole argument in a sentence : gold cannot go until ex- 
change reaches a very high rate ; but a high rate of exchange 
stimulates exports ; the increase in exports presses down the 
rate of exchange ; and the lowered rate of exchange stops the 
outflow of gold. 

Not only is an outflow of money stopped by the automatic 
reversal of the condition which makes it possible, but, further, 
a persistent net movement of money tends to be stopped or 
even reversed by the action of conditions which its own con- 
tinuance establishes. Three processes may be distinguished. 



38o PRINCIPLES OF ECONOMICS 

First, a money drain from any country makes the surplus 
banking reserves from which money for export is taken, in 
the chief commercial centers (London, New York, etc.) rel- 
atively small. Depletion of the surplus reserve will raise the 
rate of discount — interest collected in advance — on short time 
loans ; since the rate on this kind of loan is almost entirely de- 
pendent on the size of the surplus reserve. A high rate of dis- 
count thus established will make the country a desirable mar- 
ket for lenders, and so will tend to draw in the floating capi- 
tal of other countries. 

Ordinarily this process is adequate to stop an excessive 
drain of money; but, if it does not prove so, a new and slight- 
ly different series of reactions follow and usually effect the 
desired result. When the central banking reserve becomes 
scanty, the inclination of people to buy or hold international 
securities, — 'the trade in which is usually based on borrowed 
capital, — rapidly diminishes. With a fall in demand, the price 
of securities also inevitably falls. But a lower price for se- 
curities will encourage foreigners to buy them, thus giving 
New York an abundant supply of exchange on Europe. Final- 
ly, since, as we have already seen, abundant exchange means a 
low rate of exchange, the condition necessary to further out- 
flow — a high rate of exchange — is thus removed. 

There is yet a third chain of causation which comes into 
operation probably a little later than the others. The same 
high rate of discount which causes a fall in securities, if long 
enough continued, leads to a fall in the prices of the great ex- 
port staples, such as cotton and wheat, which are speculated 
in like securities. This fall in price leads to increased buying 
by foreigners, which makes foreign exchange abundant, thus 
lowering the rate of exchange, and checking the outflow of 
money. Finally, if the outflow went on long enough to pro- 
duce a scarcity of money in the country as a whole, there 
would result a general fall in prices, which would stimulate 



MOVEMENTS AND DISTRIBUTION OF MONEY 381 

foreign buying all along the line until the direction of the 
money movement was completely reversed. 

The foregoing arguments would seem to establish beyond 
question the following principle : 

Principle II. Every net movement of money tends to be 
stopped, or even reversed, by the automatic reversal of that 
condition which is necessary to bring it about, or by the action 
of conditions which its own continuance sets up. 

From the above principle it is only one step to the follow- 
ing corollary : 

Corollary. There is never any danger that an outflow of 
money from a particular country will go on till that country 
is denuded of its monetary stock. 

Every net movement of money, even a moderate one, 
tends automatically to bring about its own stoppage. But, ob- 
viously, if this is true of every net movement, it would prove 
to be true of any movement so extensive that it threatened 
the complete exhaustion of the money stock. 

Another important principle regarding the distribution of 
the money stock, and one which is little more than a corol- 
lary from the last may be stated as follows : 

Principle III. Generally speaking, the monetary stock 
of a country, or group of countries having the same standard, 
tends to distribute itself according to relative need. 

If the need of any particular country, as compared with 
other countries, is less completely satisfied, this fact alone will 
tend to start a process of redistribution, which continues till 
the several needs are satisfied in equal measure. The explana- 
tion of this process has already been anticipated. If the stock 
of money in one country, as compared with another, is small 
relatively to the money work to be done, this fact will show 



38a PRINCIPLES OF ECONOMICS 

itself in deficient bank reserves, and such a deficiency, causing 
the rate of discount to rise, will bring an inflow of money for 
investment. A high rate of discount will, moreover, cause the 
prices of securities and of the great staples to fall, again re- 
sulting in an inflow of money. The process by which an ex- 
cess in any country is corrected by an outflow to other coun- 
tries is simply the reverse of those described. There first re- 
sults from the excess an expansion of the bank reserves ; large 
reserves bring down the rate of discount, making investments 
unprofitable ; and this will cause capital — and, in time, money 
— to be exported. The low rate of discount will, moreover, 
occasion a rise in the prices of securities and the great staples ,' 
foreigners will then begin to sell freely on our markets, thus 
expanding our foreign debt; and a large foreign debt, raising 
the price of exchange, will very quickly result in the export 
of money. 

The above argument treats of movements occurring be- 
tween highly developed commercial nations having the ordi- 
nary economic relations. As between small communities 
where standard money metal is produced, — for example, 
South Africa and the Klondike, on the one hand, and the rest 
of the world, on the other, the working of things is, if any- 
thing, more simple. The extraordinary abundance of money 
( for in such places gold, even in its raw form, at once becomes 
money) and the great scarcity of all other goods make prices 
excessively high ; as a result, goods flow in at an extraordinary 
rate; the community has constantly a large balance of indebt- 
edness against it; and money must constantly be sent out. 

Up to this point our discussion has placed a special em- 
phasis upon the self-regulative character of monetary distri- 
bution. If taken in too absolute a sense, this might lead to a 
misunderstanding. The last of our principles governing the 
movements and distribution of money must, therefore, be one 
which in some degree qualifies those heretofore laid down. 



MOVEMENTS AND DISTRIBUTION OF MONEY 383 

Principle IV. While, in general, the proper distribution 
of the world's monetary stock among the different nations can 
safely be left to the working of automatic forces, circum- 
stances may arise under which it is desirable consciously to 
control particular movements of money, in order to mmntain 
the stability of the system of credit. 

In a typical monetary system of our day, a large part of 
the total monetary stock consists of representative or credit 
money and bank credit. Under such an order, the foundation 
of standard money is vastly more important than any other 
constituent of the circulating medium; it is not mere money; 
it is emphatically the basis of the zvhole system. This is par- 
ticularly true of that portion of the stock of standard money 
which we call the ultimate reserve, the reserve kept by a great 
central bank or, as in the United States, by the government, 
to redeem credit money. To maintain this reserve in adequate 
volume is of the greatest moment, not because we need it as 
a medium of exchange, but because, if it proves inadequate, 
the whole system will fall in ruins. 

Accordingly, it is natural that every extensive movement 
of standard money should be jealously watched with reference 
to its possible bearing on the ultimate reserve of the system. 
When that reserve is being drawn down, it is not enough to 
say -that, in the long run, an excessive drain will correct it- 
self. We cannot afford to wait for the long run, — serious 
consequences may overtake us in the meanwhile. The disap- 
pearance of the ultimate reserve would mean the overthrow 
of the standard; and even the beginning of a depletion which 
threatened to be at all serious would excite such anxiety in 
the business world as gravely to injure industry and perhaps 
precipitate a panic. A nation may, for example, find itself 
experiencing the specie drain incident to a great war, a drain 
for which automatic regulation will not furnish a sufficiently 
strong or sufficiently rapid check. Or there may be a drain 



384 PRINCIPLES OP ECONOMICS 

arising from the action of unwise statutes or other artificial 
conditions, which at the very best cannot be changed for a 
long time. In such circumstances, it might easily be the duty 
of the government, or the great central bank, to take active 
and vigorous measures to check an outflow of standard 
money.* 

Il^IvUSTRATlVE PrQiBIvEMS 

1. "When I came to Marblehead they had their houses 
built by country workmen, and their clothes made out of town, 
and supplied themselves with beef and pork from Boston, 
which drained the town of its money." — Barnard's Autobiog- 
raphy. Criticise the part in italics. 

2. During the years 1853 to 1864, inclusive, when France 
had a system of bimetallism at a coinage ratio of 15.5 to i, 
while the market ratio was about 15.3 to i, the French circu- 
lation absorbed about $680,000,000 of gold, and ejected about 
$345,000,000 of silver. Explain these facts, using one of the 
corollaries of Principle I. 

3. Between America and Europe there is usually a net 
movement of money toward Europe during the second quar- 
ter of the year, toward America near the end of the third, and 
early in the fourth, quarter." Explain why you would expect 
this to be true. 

4. "A country has never been despoiled of its money by 
the working of its international trade." — Gide's Political Econ- 
omy, p. 120. Why does he feel so sure about this? 

5. A New York wheat broker sells 50,000 bushels of 
wheat to a Liverpool miller, and sells against it a sight bill of 
exchange for the proceeds, £8735 i6s. The wheat cost him 
84 cents per bushel. 

(a) With exchange on London at $4.88, what would his 
profits be? 

(b) What would they be with exchange at $4.84? 

* The most important device employed for this purpose consists in 
raising the rate of discount, and thus bringing into operation Corollary 
I of Principle I. 



MOVEMENTS AND DISTRIBUTION OF MONEY 385 

(c) What does this have to do with money movements? 
Explain carefully. 

6. "Between New York city, as the banking center of the 
United States, and the country at large, there is usually a great 
money movement outward from New York during the sum- 
mer and early fall, and an inward movement toward New 
York during the late fall or early winter." Explain why you 
would expect this to be true. 



CHAPTER XXV 

PRINCIPLES GOVERNING THE VALUE OF 
MONEY 

Thus far in our discussion of money we have treated it 
as a thing apart from the general field of economic goods, a 
thing peculiar, and governed by laws of its own. Again, in 
our chapters on Price (Chapters XIV to XX), we for the 
most part spoke of economic goods as if money, the thing in 
which the prices of those goods is expressed, were not to be 
considered as one of them, essentially the same in kind and 
governed by the same laws. But these implications are mis- 
leading. Money is in a sense an economic good, just as wheat 
or cotton are economic goods, and the time has now come 
when we must so treat of it. We must show that money, the 
thing in which the values or prices of most other goods are 
expressed, is itself subject to the laws of value and price. 

The chief defect in our earlier reasoning lay in the assump- 
tion that money was constant in value. This assumption was 
encouraged by our emphasis on the idea that the money unit is 
tied to a certain definite quantity of substance, say 25.8 grains 
of gold, just as a gallon measure is tied to 8.33 pounds of wa- 
ter. But, as a closer examination will disclose, any such 
view is decidedly inaccurate. 

The cases of the money standard and the liquid-measure 
standard are not properly analogous. In using 8.33 pounds of 
water as a standard of liquid measure, we need have no anxie- 
ty that the bulk of the water itself will change, and so cause 
that of our unit to change ; for we can make those conditions 
which zvotdd modify the bidk of water — temperature and at- 
mospheric pressure — absolutely the same in all times and 
places. 



THE VALUE OF MONEY 387 

But we cannot parallel this operation with gold and its 
value. We can not say that we will have as our money stand- 
ard the value of 25.8 grains of gold under just the same con- 
ditions as prevailed zvhen it was finally adopted in 1873 ; for 
we can never reproduce those conditions. All we can do, and 
all we try to do, is to keep the value of one dollar equal, at 
any particular time, to the value of 25.8 grains of gold at that 
same time. In doing this, we anchor the value of the dollar 
to a value which itself changes, and so, of course, the value 
of the dollar will change. Doubtless our policy in this matter 
is, on the whole, wise ; for the value of gold changes very 
slowly, perhaps more slowly than that of any other single com- 
modity, and, anyhow, we ought to have the same standard 
as the rest of the world, which is gold. But, whether wise or 
not, this policy anchors our money to something which chang- 
es in value, and so the value of our money changes, instead of 
remaining constant, as has all along been assumed. 

But, although changes in gold and money value do occur, 
it is not so easy to establish the fact of change or to measure 
its extent as the student might imagine. Gold, being the stand- 
ard of all great commercial nations, there is practically no 
market where its value is expressed in terms of anything but 
the money unit. There is, therefore, practically no place 
where the apparent value of gold and money alters at all. In 
the United States, 25.8 grains of gold is always worth one 
dollar and, conversely, one dollar is always worth 25.8 grains 
of gold. Hence, our only method of ascertaining changes in 
the value of gold and money is to study the movements of the 
prices of other things. If gold, and so money, should all at 
once greatly rise in value, their own price — in terms of each 
other — would remain constant, but that of goods and serv- 
ices in general would fall. Conversely, a sudden fall in the 
value of gold and money would show in a rise of the prices 
of all other things. It would seem, therefore, that we need 
only ascertain the changes in the general level of prices to 



388 PRINCIPLES OP ECONOMICS 

know the changes in the value of money ; and, in large meas- 
ure, this is what we try to do. 

But we scarcely begin an application of this formula 
when we run upon difficulties of a most serious nature. Chang- 
es in the value of money would surely express themselves in 
opposite changes in the level of prices. But the level of prices 
may also be afifected by a sudden collapse of business demand 
or a great fall in cost of production. In other words, a change 
in the general price level may really be, not a change in the 
value of money, but a change in the value of goods. Or, to use 
a better expression, some changes in the general level of prices 
have their origin in causes affecting goods rather than mon- 
ey ; and, if called changes in the value of money at all, these 
may be distinguished as relative changes, while changes in the 
price level due to causes acting on money itself would be called 
absolute changes. 

A familiar instance of a relative change is the follow- 
ing. When, after a period of industrial stagnation, business 
begins to pick up, and people regain their faith in the future, 
there naturally takes place an expansion of demand for goods 
of all sorts, and in consequence a measurable rise in prices, 
starting among a few commodities but gradually extending 
until it covers, if not the whole field, at least a large portion 
of it. As the boom advances, this movement becomes more 
and more pronounced. Every one, believing prices will go 
higher, is eager to buy, that he may have something to sell 
at the higher prices ; and, of course, his eagerness to buy 
means more demand and so contributes to the very price ad- 
vance which he expects. This self-propagating movement 
continues until the expansion has passed all reasonable bounds, 
when suddenly some accident precipitates a general collapse 
of the boom, — pricks the speculative bubble. At once all are 
eager to sell, no one wanting to buy ; and this sudden expan- 
sion of supply and contraction of demand causes a falling-off 
of prices, more rapid probably than the rise has been. These 
changes all take place, not because anything has happened to 



THE VALUE OF MONEY 



389 



money, but because something has happened to people or to 
goods. 

Take another illustration. If throughout a period of some 
length, say between 1850 and 1890, technical methods gen- 
erally undergo a rapid improvement so that the costs of pro- 
ducing large numbers of commodities are much reduced, there 
naturally follows a decline in the prices of these commodities 
so great as to lower markedly the average, or general, price 
level. But such a lowering of the general price level could 
not properly be conceived as a real or absolute advance in 
money. In a very natural sense of the terms it is not a change 
in the value of money at all, but rather a change in the value 
of goods. 

So much for relative changes. In a study of money, how- 
ever, it is of course not the relative changes, but the absolute 
changes which are really germane. Our reference to changes 
in the general price level have been made merely to guard 
against the danger of confusing them with genuine changes 
in the value of money. We turn now, therefore, to the real 
task of our present chapter, the analysis of these genuine, 
absolute changes. 

The principle governing the value of money which is looked 
on by the majority of economists as most truly fundamen- 
tal is known as the quantity theory or principle. 

Principle I. The value of money in any country tends to 
vary inversely as the quantity of money in that country. 

The argument for the quantity theory runs somewhat as 
follows: If the quantity of money increases, people in general 
will have more to sepend, will, therefore, demand more goods. 
But, if people demand more goods — no corresponding increase 
in such goods being provided for in the hypothesis — prices in 
general are certain to rise. Finally, such a rise in general 
prices is the same thing as a fall in the value of money. On 
the other hand, if the quantity of money diminishes, people 
will have less money to spend, will, therefore, demand fewer 



390 PRINCIPLES OP ECONOMICS 

goods, and so prices will fall ; that is, the value of money will 
rise. 

This argument, though an a priori one, has at times been 
strikingly confirmed in experience. Thus, in a community 
which contains only a few thousand inhabitants there may 
occur a great gold discovery, producing, in a few months, bul- 
lion to the value of hundreds of thousands of dollars. As this 
bullion can be almost instantly turned into money or its equiv- 
alent bank credit, the money demand for all sorts of goods 
will at once greatly expand. In the output of goods, on the 
contrary, there will be no corresponding increase. Conse- 
quently, the prices of goods in general show a rapid rise. And, 
since this rise is caused by the increase of money or its cheap- 
ening (in cost) or both, it constitutes a real or absolute fall 
in the value of money. In gold producing districts, such as 
California, Australia, and the Klondike, the new gold was gen- 
erally used as money at once, in its bullion form, without 
waiting for coinage. The eager spending of this new metal 
to buy the necessaries and luxuries which the hitherto poor 
miners craved, naturally led to a swift advance of almost all 
prices, that is, a swift fall in gold. 

The application of the principle in a small community is 
thus easily shown ; but does it apply as well to an entire coun- 
try, or to a whole group of countries? In such a country, or 
group of countries, will the value of money tend to vary in- 
versely as the total quantity of money f 

An addition of 200 million dollars' worth of gold to the 
world's stock must surely tend to modify the gold, or money, 
demand for all goods other than gold, and so to modify the 
value of gold as measured in those goods. The new gold, or 
much of it, will be coined and pass into the monetary stock 
of the world; this will mean a corresponding enlargement of 
the ultimate reserves to which gold money is mainly relegated ; 
and this enlargement in turn will lead to an expansion of 
bank credit, and so of general purchasing power. As a re- 
sult, buyers will find it easier to get possession of purchasing 



THB VALUE OF MONEY 



391 



power. If they are already disposed, on other grounds, to go 
into the market as buyers of wheat, cotton, machinery, etc., 
the increased control of buying power will increase the de- 
mand for those goods. Finally, the increased demand will 
tend to raise the prices of those goods or, in other words, to 
lower the value of gold. 

In a large country or in a group of countries, however, this 
process cannot be looked for with anything like the same de- 
gree of confidence as in a limited district. That the value of 
money tends to vary inversely as money quantity, assuming 
that sufficient emphasis is laid upon "tends," would seem al- 
most indisputable. The norm toward which the actual value 
of money gravitates, about which it varies under the influence 
of more temporary causes, is in large measure determined un- 
der the principle noted. Nevertheless, this doctrine requires 
much qualification. Historical and statistical studies have se- 
riously undermined it, and not a few economists have been 
tempted to reject it altogether. In the opinion of the writer, 
the doctrine contains a basis of truth which is of prime im- 
portance. But the limitations to which it is subject in actual 
experience and which seem at times to reduce its practical sig- 
nificance almost to nothing, must be clearly understood. 

First, so far as gold, the standard money is concerned, 
the quantity in existence changes so little in a year, or even 
in a long series of years, that, however true the theory might 
be, we should have great difficulty in establishing a satisfac- 
tory proof of it. In the case of many commodities, as for 
example wheat, the output of a year constitutes almost the 
entire stock for that year, and a doubling of the output means 
almost a doubling of stock. But not so with gold. Its physical 
imperishability, its very high specific value, and its technical 
treatment as money make it, economically considered, immor- 
tal. It is almost never consumed in the sense of being irre- 
vocably withdrawn from the market. The untold accumula- 
tions of the centuries are in large measure available to meet 
the needs of today. In consequence, an increase or decrease 



392 



PRINCIPLES OF ECONOMICS 



in the output does not cause anything Hke a corresponding in- 
crease or decrease in the stock. The stupendous additions 
necessary to make a change in stock sufficient to show in a 
perceptibly changed value virtually never occur. 

Another limitation, or set of limitations upon the quantity 
theory grows out of the fact that in any modern monetary 
system, purchasing power, stated in terms of money, is not 
rigidly fixed by the quantity of money, but is almost indefi- 
nitely elastic. The whole point of the theory, as we have 
seen, lies in the assumption that if people have more money 
they will demand more goods, and that if they have less money 
they will demand less goods. It is easy, however, to show 
that this argument rests on a very shifting foundation. 

First, a small quantity of money, frequently turned over, 
will demand as much goods as a large quantity of money cir- 
culating slowly. Money demands goods every time it is spent 
or offered in exchange ; and when it is not being offered in ex- 
change it is not demanding goods. Hence, as the saying is, 
the nimble sixpence may do the work of the slow shilling. In 
a word, rapidity of circulation may neutralize any tendency 
to a rise in value caused by scarcity of money, and slowness 
of circulation may neutralize any tendency to a fall in value 
caused by an abundance of money. 

Second, if the quantity of money did cause a change in 
money values, and that change were thought undesirable, 
there would be no reason, under modern conditions, why the 
defect in quantity should not be speedily corrected. As re- 
gards gold itself, a deficiency in one country is easily made 
good by imports from elsewhere, while an excess is easily re- 
lieved by exports. But even if the quantity of gold were not 
alterable, — and, as we have seen, it is not perceptibly altera- 
ble in all countries at once, — this would be of no great con- 
sequence. Only a small proportion of the actual circulating 
medium, the buying power in money form, consists of gold. A 
much greater part consists of bank notes, secured by small re- 



THE VALUE OF MONEY 



393 



serves of gold, and the issues of these may be expanded of 
contracted at will. 

But there is an even more important consideration. The 
general course of wholesale prices is largely determined in the 
great exchanges where wheat, cotton, iron, petroleum, and so 
on are dealt in. Now, the exchange medium employed at these 
markets is not money in the narrow sense, but rather credit. 
Cotton, wheat, and iron are paid for with checks, and these 
checks practically never lead to a call for cash — the transac- 
tions are carried on almost entirely with deposit currency. 
But this sort of circulating medium expands or contracts vir- 
tually as it is needed, expands or contracts, indeed, with the 
expansion or contraction of the very business which employs 
it. Just because a dealer has bought 50,000 bushels of wheat, 
he can induce his banker to manufacture on his behalf say 
$30,000 in credit money, secured by that wheat, and ready to 
be used in buying more wheat. The new wheat, in turn, can 
be made the basis of additional bank credit, which again can 
be used in buying still more wheat. 

There must always exist, to be sure, a basis of real money ; 
every new bank loan must be secured by a certain reserve of 
standard coin or metal; but the possible expansion of the loan 
is several times as great as the necessary addition to the re- 
serve. Hence if business prospects look favorable both to 
the would-be borrower and the bank, the purchasing medium 
can be and will be expanded almost indefinitely, with only the 
slightest dependence on the stock of money existing at the 
time. On the other hand, if prospects are not favorable, the 
buying medium, deposit currency, will not expand, no mat- 
ter how large the reserves of real money. So, here again it 
appears that the quantity of money has little to do with de- 
termining the demand for goods. Demand expands or con- 
tracts according to general business conditions, creating or 
destroying its own medium of exchange as the need arises or 
disappears. Hence the quantity of money appears to have 



394 PRINCIPLES OF ECONOMICS 

little effect in determining changes in the absolute value of 
money. 

Nevertheless, with all these qualifications, the quantity- 
theory, as a statement of a general tendency, remains un- 
shakeable. Given more money to spend and no more goods 
to spend it for, the price of goods will rise, which means 
that the value of money will fall ; and given less money to 
spend but the same amount of goods to spend it for, the price 
of goods will fall, or the value of money rise. It may require 
a really stupendous addition to or deduction from the exist- 
ing stock before any change in value traceable to it can be 
discovered ; it may require a comparison of two very extended 
periods, the one having a per capita circulation twice as great 
as the other, before any difference not due to merely relative 
changes can be detected. Yet without doubt the tendency does 
exist — the quantity of money does operate to affect its value. 

If the value of money varies inversely as the quantity, we 
should need little argument to establish certain facts con- 
cerning the effect upon value of various forces that influence 
the quantity. Since the output of money metal increases the 
stock, it must tend to diminish the value of money. Since a 
high cost of production tends to diminish output, and a low 
cost of production to increase output, then the one must tend 
to raise and the other to lower value — although, due to the 
highly speculative character of mining, this cause does not 
operate with anything like the promptness or certainty char- 
acteristic of many other industries. Finally, since the in- 
crease or decrease of money metal used in the arts must affect 
opposite changes in the amount of such metal available for 
use as money, they necessarily tend to increase or decrease 
the value of money. 

The facts just mentioned may all be briefly stated in a 
corollary of Principle I. 

Corollary. The value of money tends to vary inversely 
as the quantity of standard money available, and hence to 



THE VALUE OF MONEY 395 

vary inversely as the output of metal, directly as the cost, and 
directly as the quantity used in the arts. 

While the quantity principle is the basal doctrine for 
money values, special circumstances may arise in which one 
or two other principles have greater influence. Thus, the 
value of the substance used for the monetary standard may at 
times be determined quite independently of the quantity of 
money, and then the value of money be fixed in accordance 
with the value of this ultimate standard substance. When- 
ever the value of the ultimate standard changes, as measured 
in at least one important commodity, then the value of the 
money dependent on that standard will also change. Business 
men of experience, alert and shrewd, will certainly refuse to 
sell goods at the old prices for money which, as measured in 
an altered ultimate standard, has fallen twenty or thirty per 
cent. And if they proceed to raise prices, this will constitute 
a change in the value of money by adjustment to a changed 
ultimate standard. 

Suppose the standard of a country is a metal which has 
the status of a mere commodity in some great world market 
where the country in question maintains intimate trade rela- 
tions. Thus before 1893, India had a silver standard. At 
that time, as now, silver was in London and other European 
centers a- mere commodity, bought and sold like cotton or 
wheat. Naturally, it showed many fluctuations in price ; and 
every marked fluctuation was followed by an opposite change 
in Indian prices, particularly of imported goods. When silver 
fell, Indian prices rose ; when silver rose, Indian prices fell, — 
in a word, the value of Indian money was readjusted to varia- 
tions in the world price of silver. This result was, of course, 
the natural one to expect. If silver fell, the value of Indian 
silver rupees, as measured in English pence, would fall; it 
would take more of them to buy the goods imported from 
Europe ; and so the dealer would have to recoup himself by 
charging more for the goods. But, if dealers in imported 



396 PRINCIPinS OP ECONOMICS 

goods charged more, dealers in domestic goods would in the 
long run have to do the same, or else suffer a loss. Finally, 
if dealers in general charged more for their goods, laborers 
would presently have to begin charging more for their serv- 
ices. A rise in prices begun in the import trade would thus 
eventually be extended throughout all business relations. And 
this is merely to say that the value of the rupee was being ad- 
justed to the value of silver. 

A second illustration. Suppose the standard money con- 
sists of irredeemable notes. Changes in the value of this 
money, as measured in the metal which was formerly stand- 
ard, can be followed in the market price of that metal. Thus, 
during the American Civil war, gold went out of circulation 
and was speculated in on the open market just as cotton, 
wheat, and copper are now. Every day, every hour, its price, 
measured in greenbacks, the standard money which had dis- 
placed it, rose or fell. But this, of course, is the same as 
saying that the value of greenbacks, measured in gold, moved 
in the opposite direction, — fell or rose. Naturally, every seller 
of goods would note these changes in the greenback, since it 
was the measuring unit of the values of the goods he was 
selHng. Naturally, too, he would sooner or later make some 
effort to guard himself against loss from the fall in green- 
back values. Doubtless he would not try to readjust his prices 
to every change, but we can be quite sure that great declines, 
especially if long continued, would lead to a remarking of 
goods, a readjustment of prices to correspond to the decHne 
in standard money. 

As a formal statement of the points here illustrated, we 
have the following: 

Principle II. Whenever the conditions are such that it 
is possible for the general public to have fairly conclusive evi- 
dence that a change in the value of the ultimate standard, as 
measured in at least one important commodity, has taken 



THB VALUE OF MONEY 397 

place, there will almost certainly follow, more or less rapidly, 
a direct readjiistment of the value of money (and so of geti- 
jeral prices) to the changed ultimate standard. 

A third principle concerns the value of irredeemable pa- 
per money as affected by political or commercial uncertainty. 
Irredeemable paper money is merely credit money which has 
hitherto been redeemed freely on demand in the standard 
money, but on which, for the time being, redemption has been 
suspended. The type we have in mind is issued by the pub- 
lic treasury or a central bank closely allied to the Treasury, 
for example, The Bank of England. When payment on such 
money has been suspended, it- inevitably becomes the standard 
money as shown on page 356. Now, in normal times, when 
no public crises intervene, the value of money of this sort 
may remain at about the same point for months or even 
years. That point will be below the value of the standard 
displaced, but not necessarily much below, depending on the 
quantity out, the skill with which it is managed, etc. But, if 
any period is marked by uncertainty in public and commer- 
cial affairs, for example, if the nation is engaged in a war 
characterized by greatly fluctuating fortunes, anxiety will nat- 
urally spread abroad lest the Government will in greater or 
less degree repudiate its obligations. This failure of the 
public confidence will of course react on the value of the notes 
as measured in the old standard, causing that value to show 
extraordinary fluctuations even within the limits of a single 
day.* But this will not be the end of the matter. As brought 
out in discussing Principle II, dealers will more or less fully 
adjust their prices to the larger changes in the value of the 
irredeemable paper as measured in the old standard. The 
final result then, will be that the value of such money, as 
measured in goods in general, will vary in a rough way with 



* As seen in opposite changes in the value of the old standard 
metal, quoted in terms of the irredeemable note. 



398 PRINCIPLES OF ECONOMICS 

the degree of the public confidence in the certainty and prox- 
imity of its redemption. The following statement will formu- 
late the conclusions of our argument. 

Principle III. During a period marked by much uncer- 
tainty, either political or commercial, the value of irredeem- 
able paper money is chiefly determined by public confidence in 
its ultimate redemption, varying directly as said public con- 
fidence. 

MISCELLANEOUS PROBLEMS UNDER MONEY 

1. "I can't understand what people mean when they 
say that money has risen in value since 1873. Money is by 
common consent the measure of the values of all other things ; 
and so its own value must be fixed, — cannot rise or fall." — 
From a gold advocate in 1896. Explain his mistake. 

2. Why would changes in the total quantity of money 
in the United States between 1862 and 1879 naturally have 
had more influence on its value than equal changes would 
have had between 1850 and i860? 

3. Extract from a speech in the campaign of 1896 : "If 
any man in this community would ofifer to buy all the eggs at 
25 cents a dozen and was able to make good the offer, nobody 
would sell eggs for less, no matter what the cost of produc- 
tion, whether one cent or five cents a dozen. So with silver. 
Free coinage zvould establish the market price of silver at 
$1.29, and nobody would sell for a cent less." 

There is doubtless a sense in which the italicized claim is 
true but this is not the sense which was intended. The speaker 
meant that silver would rise to $1.29, as measured in the pres- 
ent dollar ; so that there would be no repudiation of debts in 
adopting the free coinage of silver. 

(a) Show that such a claim is not established by this 
argument. 

(b) In what sense is the statement true? 

4. "We have altogether too little money in the country 
($2,600,000) not enough to pay the railway debt ($6,000,000), 
or even the debts of banks to depositors, let alone the business 
debts." Explain fallacy. 



THB VALUE OP MONEY 399 

5. A few years ago Mexico had a silver standard. If at 
that time silver had risen in value, would the Mexican dollar 
have risen in value ? Would it have risen in price ? Would the 
price of silver bullion have risen? 

6. In 1856 the monetary system of France was bimetal- 
lism at the ratio of 15.5 to i. The market ratio at that date 
was about 15.3 to i. What must have been the monetary 
standard ? Prove. 

7. In the panic of 1893, when in America money was so 
scarce that business men and bankers had to resort to all 
sorts of substitutes, such as due bills, New York drafts, de- 
posit certificates, etc., an eminent American economist said in 
substance : "What do you think now ? Was I not right in con- 
tending that the stock of money is altogether insufficient?" 
Did the facts establish his contention? 

8. Argument against Bryan in the campaign of 1896: 
"I can see how free coinage is going to increase the profits of 
the mine owners hy doubling the value of silver; but I do not 
see how it is going to help the rest of us." Explain the fallacy 
in the words italicized. 

9. During the sixth decade of the XIX Century when 
France had bimetallism at a ratio of 15.5 to i, though the mar- 
ket ratio was about 15.3 to i, dealers to their surprise every 
now and then received silver five-franc pieces in payment for 
goods. Why should this have surprised them? 

10. Unless the government redeems all worn coins at 
their face value, a coinage in active use always shows a strong 
tendency to deterioration." Explain why this is bound to be 
true. 

11. "I object to our buying outside anything which we 
can produce at home ; for this means just so much money 
lost from our coin circulation." Show that this is unsound. 

12. About 1850, when the United States had bimetal- 
lism at a ratio of 16 to i, there took place a considerable fall 
in the silver price of gold, so that the silver in an American 
silver dollar was worth 2 to 3 cents more than the gold in a 
gold dollar. In consequence, silver coins generally went out 
of circulation, only the much worn ones remaining. Explain 
(a) why most went out and (b) why some stayed. 



400 PRINCIPLES OF ECONOMICS 

13. What is meant by saying that our mint ratio be- 
tween gold and silver was i to 15.98? 

14. "New York, Dec. 11, 1903. The banks gained from 
the interior this week $2,042,906." Newspaper. Was this nor- 
mal? 

15. "London, Oct. 3. One hundred and fifty thousand 
pounds sterling gold will be shipped tomorrow to New York." 
Was this normal ? 



CHAPTER XXVI 

THE PRESENT SYSTEM OF DISTRIBUTION 

It is a fact of every day observation that the economic 
incomes enjoyed by different persons or famihes are very un- 
equal in amount. Unskilled laboring men have to content 
themselves with perhaps two dollars per day ; skilled labor 
can demand five dollars or more, and professional men from 
ten dollars upward ; while in the world of business and fi- 
nance we may, without searching very far, find men who re- 
ceive for their services more money in a minute than the labor- 
ing man does in a year. Even more conspicuous is the fact 
that the totals of accumulated wealth owned by different per- 
sons or families are very unequal. We have at the one ex- 
treme multitudes of persons who own only a small property, 
or perhaps no property at all, and at the other extreme not a 
few individuals whose wealth mounts up to the millions. 

This inequality of incomes and possessions would, like any 
other notable phenomenon, demand scientific explanation even 
if no great human interests were involved. But human inter- 
ests are involved, and very deeply — inequality in matters of 
wealth is one of the most trying facts in the lives of men, and 
hence the study and discussion of that inequality inevitably 
become of very exceptional importance. Accordingly, the 
economist has in every generation, and in ours most of all, 
spent much time trying to answer questions like these : What 
are the incomes received by different classes of persons? Un- 
der what general and specific principles are these incomes at 
present determined? Is the result entirely reasonable or just? 
If not, what is to be said for and against the various projects 
brought forward to improve matters? Such questions as these 
suggest pretty fully the scope of that division of economics 



402 PRINCIPLES OF ECONOMICS 

commonly known as Distribution; and we shall, for the pres- 
ent, at least, attempt no more formal definition. In the present 
chapter, our task will be to study the existing system of dis- 
tribution in its more general aspects. 

Section A. The Principal Kinds of Income 

The principal kinds of income are wages, rent, interest, 
and profits. These terms have already been used in various 
connections, and we should have no difficulty in understand- 
ing their meaning. Wages are the income which men receive 
in return for personal services — labor. Interest is the capi- 
talist's remuneration for waiting, and takes its purest form 
in loans where risks are practically eliminated. Profits, on 
the other hand, are the remuneration paid especially for tak- 
ing the risks or, better, for taking the responsibilities of own- 
ership. Rent is the hire paid for the use of unproducible or 
indestructible elements in land. 

These incomes, it should be noted, are strictly economic, 
in contrast to others which might properly be called non-eco- 
nomic. Economic incomes are those, like wages from the sale 
of labor, which arise directly out of economic activities. Those 
of the other type arise outside of economic activities, from 
gift, theft, or accident. Some incomes, to be sure, can with 
more or less reason be assigned to either class. Thus, many 
of the great incomes obtained in America from the exploita- 
tion of natural resources, such as lumber, copper, and oil, 
which we usually classify under one of the regular economic 
shares — profits — may also be conceived as in a sense non-eco- 
nomic, in that they often have their origin in the foolish or 
corrupt munificence of government. Naturally, the study of 
incomes undertaken here will be largely concerned with those 
which can properly be called economic. 

Again, we should note as a general point that economic 
incomes are of two distinct classes — personal incomes and 
property incomes. Personal incomes, which men receive in 



THE SYSTEM OF DISTRIBUTION 403 

exchange for personal services, may in practically all cases be 
brought under the category of wages, though in ordinary 
speech remuneration for the higher forms of personal service 
is usually called salary. Property incomes, those which men 
receive in exchange for services given by the property they 
own, fall into three classes, rent, interest, and profits. 

ILI.USTRATIVE PrOBIvEMS 

1. Mr. Crane puts $3,000 into a grocery business and 
works himself in the store from morning till night. His net 
return from the business is $1,500. 

Make an imaginary distribution of this income into the 
several economic shares which are probably involved. 

2. My friend has eight houses and lots in Ann Arbor 
which he rents, getting for each, let us say, $360 a year. Try 
to break up this sum into the different elements which prob- 
ably enter into it. 

3. At a certain inland resort rowboats are let at $1.50 per 
day. Enumerate the different elements entering into this sum. 

Section B. General Character of the Process Determining 
the Regular Economic Shares 

The four economic shares, then, are wages, rent, interest, 
and profits — these comprise the four economic sources of the 
livings that men get. The next question is, How are the 
amounts of various incomes determined? To put the matter 
concretely, suppose we have an automobile factory. How 
does it come about that I, as a laborer therein receive thirty 
dollars a week for my services ; that you, as owner of the land 
on which the factory is built, receive $5,000 a year for the 
rent of it; that a third party who has loaned the money with 
which the factory was erected, the machinery bought, and 
with which, perhaps, you and I are paid, receives five per cent, 
on his capital; that, finally, the man at the head of the whole 
concern receives half a million a year for undertaking to pro- 



404 



PRINCIPLES OP ECONOMICS 



duce automobiles, and bearing all responsibility for their pro- 
duction? The factory, in short, or the total product of the fac- 
tory, constitutes the source from which the laborer, the land- 
lord, the capitalist, and the entrepreneur all derive their in- 
comes. Our question is, how does it happen, precisely, that 
the four shares are apportioned as they are? 

In examining the principle for the apportionment of eco- 
nomic shares, it is essential above all that we carry it intc^ 
the laboratory and treat it with scientific care. This princi- 
ple, naturally, is the chief thing which lies at the root of that 
inequality of incomes and possessions which we referred to a 
moment ago, and we are therefore tempted to view it rather 
as a moral than a scientific phenomenon, and flatly to declare 
it unjust. But, if we think with passion, we shall be apt to 
think loosely. If we condemn a thing before we understand 
it, we shall be certain not to understand it; and, until we do 
understand it, we can never be sure whether we were right to 
have condemned, or whether we should not rather have prais- 
ed. To repeat, then, let us divest ourselves of any emotional 
hindrances to clear thinking, and follow the discussion 
throughout with scientific precision. 

Generally speaking, the process whereby these regular 
economic incomes are determined is simply the price-deter- 
mining process, which we have discussed at length in earlier 
chapters. In the study of distribution, we shall find very 
few if any principles different from those already set forth. 
It will not be necessary to go outside the fundamental concept 
laid down in our second chapter, of a natural and quite definite 
economic order regulated by exchange. There is such an 
order, and Distribution, as a part of it, is governed by the 
same laws that govern the rest — the laws of exchange. 

The correctness of this view may be suggested at least by 
a mere preliminary examination of the economic incomes 
which will show that each is in reality only the exchange price 
of something. Thus wages of all sorts — whether those of a 
mechanic in the automobile factory, for example, or those of 



THE SYSTEM OF DISTRIBUTION 405 

a salesman, advertising writer, or general manager — are 
nothing but the prices of labor services brought by the la- 
borer to market. Interest also is plainly a price ; for, as we 
have conceived it, the lender makes a sale of the service of 
waiting. Rent is the price paid for the use of land unmodi- 
fied, or modified only by improvements which are indestructi- 
ble. The case of profits, though on the surface less evident, 
is at bottom not materially different. The entrepreneur sup- 
plies the service of responsibility-taking. From the very na- 
ture of this service, it cannot he sold directly ; but it is virtu- 
ally sold, in that the entrepreneur unites this service with the 
services which he buys from other agents in the productive 
process, and sells the total resultant on the general market. 
Profits, therefore, are in effect a price received for a service 
supplied. 

Another less direct but not unimportant sense in which in- 
comes are determined through exchange processes should per- 
haps be mentioned in this place. The immediate income which 
most of us receive is of course an income of money or its 
equivalent. But to realize this income, to obtain gratification 
for our wants, we have to turn the money into commodities 
or services — bread to eat, clothes to wear, rides on the train, 
etc. Now, obviously, the amount of such goods which we en- 
joy must depend in large measure on the money prices of those 
goods. But this, in turn, is a matter of exchange. Hence the 
amount of goods we can enjoy — our real income — depends, 
again, on the processes of exchange. 

But we need not be content with saying that economic in- 
comes are the prices of services rendered, and that they are 
determined, through exchange processes, by the general laws 
of price. We can be more specific. We can ascertain to what 
type of economic goods the services in question belong, and 
can then readily infer what particular law is operative in de- 
termining their prices. 

The services of labor, land, capital, and responsibility- 
taking, are what we designated in the last chapter on price as 



4o6 PRINCIPLES OF ECONOMICS 

Primary Factors, or Primary Cost-Goods. A primary factor 
or cost-good, as there indicated, is one behind which economic 
analysis cannot reach, which can be traced to no more ulti- 
mate source ; and we should be able to see with little effort 
that the factors under discussion answer completely to this 
description. 

The services of land are obviously primary factors, for 
they flow without man's assistance from a source which man 
has not made. Labor services again, for which wages are 
paid, flow from an unproducible source — labor power. For, 
although labor power is, literally speaking, produced and con- 
tinually reproduced by the natural propagation of the human 
species, it is seldom, except under a slave regime, brought 
into existence primarily for market purposes ; it occurs only 
as an incident to living and precedes the origination of eco- 
nomic motives ; and we may accordingly look upon labor as 
one of the ultimate things in our analysis, something behind 
which we cannot go. An equally clear case can be made out 
for waiting-power and responsibility-taking. These factors 
are indeed supplied by men on their own free choice, and, 
unlike labor power, are supplied from preconceived motives 
of an economic sort ; but they are preceded by no factors of a 
strictly economic kind — in reaching them we have reached a 
point beyond which economic analysis cannot penetrate. 

We have seen that the services of labor, land, capital, and 
responsibility -taking are primary cost-goods. In consequence, 
wages, rent, interest, and profits, being the prices of these 
different services, are prices of primary cost-goods. Natur- 
ally, then, the particular law of price operative in determining 
these distributive shares is the one which determines the prices 
of primary cost-goods. But the principle governing the prices 
of such goods has already been stated in the chapter on Final 
Price-Determination. It follows that the principle there set 
forth is really the general principle which in the long run gov- 
erns the regular economic incomes, wages, rent, interest, and 



THE SYSTEM OF DISTRIBUTION 407 

profits. It will be well to turn back and reread the principle 
as stated there. But for various reasons we shall present it 
here in a slightly modified form. 

Principle. — Every economic income tends to approximate 
that quantity of goods which constitutes an expression of the 
marginal significance to people at large of the actual output — 
when competition is free, the natural output — of the type of 
service rendered by the receiver of said income, and which al- 
so, in the case of free competition, constitutes an expression 
of the net marginal disutility involved in furnishing said type 
of service. 

Section C. Explanatory Comments 

It will be necessary in the chapters which follow to relate 
the above principle in detail to each of the four economic 
shares. Before commencing that, however, we had best take 
a few moments to explain exactly what the principle does and 
does not mean, thus making perfectly clear what it is that the 
arguments will try to establish. 

I. The principle is really a compound one, in that it 
asserts the coincidence of income both with the marginal 
significance of the service rendered, and the marginal dis- 
utility of rendering it. The full title of the principle, there- 
fore, would naturally be the Significance-Disutility Principle. 
It is possible, however, to treat the two parts as separate prin- 
ciples ; and this is perhaps desirable at times, because the first 
is accepted by some economists who would stick at the second. 
At any rate, the first part of the principle, which is much the 
more important and oftener the subject of reference, will cer- 
tainly require a separate title of its own. We shall therefore 
frequently allude to the "Significance Principle," which affirms 
that the price of any primary factor tends to be such as will 
express its marginal significance ; or, in other words, that any 
economic income tends to be such as will express the mar- 
ginal significance to people at large of the service rendered by 



4o8 PRINCIPLES OP ECONOMICS 

the primary factor in question. Another designation occasion- 
ally used is the "Service Value Principle," the principle that 
each person tends to get an income which represents the value 
of his service or contribution. 

2. Our principle affirms that every economic income 
tends to approximate (not equal) that quantity of goods which 
expresses the marginal significance attaching to the service 
rendered. If the marginal significance of a piece of land, for 
example, is $500, the rent paid for that land will approxi- 
mate $500, but not necessarily equal it. If the labor of car- 
penters has a marginal significance of $5.00 per day, the wages 
of this class of workmen will tend to be $5.00 per day, but 
not necessarily equal to that figure. The reason for this will 
readily be understood after our analysis of the laws of price 
as applied to primary factors. 

.In the case of primary factors of the fixed-supply kind, 
the price, as we know, tends to be fixed at some point rang- 
ing from marginal significance down to, but not including, the 
first extra-marginal significance. If these two significances 
are somewhat widely separated, price may vary consid- 
erably under the same general conditions of supply and de- 
mand. For example, let us suppose that there are twelve sites 
of a certain grade, and that a section of the demand schedule 
for these sites runs as follows : 7 wanted at $550 or any figure 
below ; 2 more wanted at $520 or any figure below ; 3 more 
wanted at $500 or any figure below ; and 3 more wanted at 
$440. Under these conditions rent could not gc above $500, 
which expresses the marginal significance of the land, but it 
could go below that figure so long as it remained above $440, 
which expresses the first extra-marginal significance (where 
fifteen applicants would appear for the twelve pieces of land). 
That is, rent would only approximate the marginal signifi- 
cance, not equal it. Usually, however, the marginal and extra- 
marginal significances will be separated by very small inter- 
vals ; not sixty dollars, as in the illustration, but one dollar, a 
few cents, almost nothing. Hence we will usually be safe in 



THU SYSTEM OF DISTRIBUTION 409 

thinking of the price of a primary factor as actually coinciding 
with the marginal significance. 

In considering producible primary factors, waiting power, 
labor, etc., we have to say that price only "approximates" the 
marginal significance, for a different reason. Here, the limits 
of price-variation may not be fixed at all by significance, but 
by disutility. If the marginal significance of carpenters' labor 
is $5.00 per day, and the first extra-marginal significance 
$4.50, the wages actually received may not be determined by 
either of these. For laborers may not consider it worth their 
while to work at $4.50, may think their labor and pain can 
be well enough paid for only at $4.75 — the marginal disutility 
price — and so they would prevent wages from falling to $4.50, 
the first extra-marginal significance price. On the other hand, 
there may be enough men to supply the demand who do not 
feel that they need as much as $5.00, even though their serv- 
ices might be worth that much to employers. In fact $4.90 
meets their notion of the remuneration they must have, and at 
that price — expressing the first extra-marginal disutility of 
doing carpenter work — more workmen begin to appear than 
employers require. Hence the wages of carpenters will not 
rise as high as $4.90. 

Clearly, then, the price of a producible primary factor may 
be hindered from equalling the marginal significance of that 
factor by the disutilities involved in supplying the factor. All 
these qualifications are, however, chiefly of theoretic interest. 
Marginal significance and marginal disutility will usually be 
separated by very small intervals. In general, it seems suffi- 
ciently accurate to say that the price of producible primary 
factors must be such as to express approximately the marginal 
significance of those factors and the marginal disutility of 
supplying them. 

3. The principle teaches that each person tends to get 
an income which represents the marginal significance of his 
services. A given employer might be wilHng to pay eight dol- 
lars a day for carpenter service. But, taking employers all 



4IO PRINCIPLES OF ECONOMICS 

together, those who are least desirous of having carpenter 
work done find the service is worth to them only $5.00 a day. 
Five dollars, in other words, expresses the marginal signifi- 
cance of that type of service. The employer who is willing 
to pay eight will therefore need to pay no more than $5.00 
per day. This is, of course, the same principle that applies in 
the purchase of bread, meat, coffee, and other ordinary com- 
modities. Whether ethically right or wrong, there is nothing 
peculiar about it. 

4. In the second part of our principle, it was said that 
every economic income tends to be one which constitutes an 
expression of the net marginal disutility of furnishing the type 
of service. The word "net" is introduced to provide for the 
following feature. The act of supplying certain services may 
involve advantages as well as disutilities; university teaching, 
for example, gives men opportunity for the pursuit of scien- 
tific investigation, and practicing law gives men standing in 
the opinion of their fellows. Now, evidently, in cases of this 
sort, the reward received by the man who supplies the serv- 
ice does not need to be large enough to express the full dis- 
utility of his task, but only large enough to express that dis- 
utiHty minus the incidental advantages. An artist, scientist, 
or missionary, however great his labor, may find such pleas- 
ure in the exercise of his talents or in contemplating the re- 
sult he hopes to achieve, that he will consider himself well 
paid if he receives only the barest living. 

5. One final comment may perhaps serve to guard 
against misunderstanding. Earlier in the chapter it was said 
that in examining the principle of distribution we ought to 
free ourselves of all preconceptions as to its injustice. It 
should now be said with equal emphasis that we ought to lay 
aside any preconceptions regarding the justice of the princi- 
ple. The latter kind of belief, accepted before examination of 
the facts, would be as fatal to our purposes as the former. In 
a later chapter, after the law is fully understood, we shall at- 
tempt a critique, presenting various reasons for and against 



THE SYSTEM OF DISTRIBUTION . 411 

the present order, and these may lead us to adopt a conclusion 
favorable to one side or the other. But, for the present, we 
should seek to entertain no ethical thesis whatsoever. The 
law of economic distribution is neither moral nor immoral, 
it is simply unmoral ; and as such we shall proceed in the fol- 
lowing pages to analyze it 



CHAPTER XXVII 

THE GENERAL PRINCIPLE OF DISTRIBUTION : 
COROLLARIES 

In affirming the truth of the general principle of distri- 
bution which has been laid down in the preceding chapter, no 
one means to teach that that principle is precisely realized 
in the phenomena of actual life. The lack of such realization 
appears in both aspects of the principle but is especially notable 
on its significance side. Few contributors to production receive 
sums which exactly correspond to their contributions. Some 
get much more ; a far larger number get less. But, in this re- 
spect, the Significance principle is not materially different from 
any other economic law. Those hypotheses which we assume 
as the starting point of all economic reasoning, absence of 
force, fraud, favoritism, monopoly, and other conditions inter- 
fering with freedom of competition and contract — are far 
from being realized. Further, were none of these manifestly 
abnormal elements present, we should still have human ignor- 
ance, folly, and inertia, to hinder any precise realization of 
the principle. 

But, while this and all other principles of economic sci- 
ence are nowhere rigidly operative, economic phenomena do, 
in a broad way, come under their control. This statement is 
more conspicuously true of some other principles than of the 
one before us, but it applies to this one also. Such being the 
case, it follows that our Significance principle should not and 
can not with safety be ignored in affairs of the practical 
world. It frequently is ignored, as we know ; for not a few 
well-meant but ill-directed reforms run directly counter to 
it. But the outcome of such reforms, just because they neglect 
the principle, is invariably a partial and sometimes a complete 
failure. To bring out the connection between such failures and 



DISTRIBUTIVE PRINCIPLE: COROLLARIES 



413 



our principle, we will set down a few of its most important 
applications in the shape of corollaries. Most of these con- 
cern the significance side of our principle ; but the last relates to 
its disutility aspect. 

Corollary i. Attempts to fix arbitrarily the amount of 
any economic share whether by governmental or private action 
zmthout changing the demand for, or the supply of, the partic- 
ular type of service involved can succeed only within the nar- 
rowest limits. 

Illustrations of such attempts are found in the Statute of 
Laborers (1351) designed to keep wages at the old level in spite 
of the diminution of laborers through the black death and, 
more recently, in minimum wage laws and usury laws. 

All these measures, we should note, are attempts arbitrarily 
to regulate the value of something ivithout changing detnand or 
supply. It is at times possible arbitrarily to change prices, but 
only on condition that one accepts the consequences in the 
shape of changed demand or supply. Thus, a monopolist may 
arbitrarily raise his price, but only on condition that he recon- 
ciles himself to smaller sales. So the workmen in a particu- 
lar trade, if very strongly organized, may put up the wages of 
their trade, but at the same time they must be content with 
fewer jobs. So, again, if government insists on establishing a 
maximum price for some producible service below the cost of 
supplying that service, it will have to be satisfied with seeing 
the supply of the service fall off. If in any particular case the 
action taken to fix prices does not alter demand and supply 
conditions, it can, as the corollary affirms, seldom succeed at 
all. 

The corollary, as stated, really contains two elements : ( i ) 
An admission that the shares can be, in some degree, fixed 
arbitrarily by legislation, and (2) A claim that this is possible 
only within very narrow limits. Let us begin with the first 
point. 



414 PRINCIPLES OF ECONOMICS 

1. Some arbitrary fixing of the shares is possible, (a) A 
share can always be arbitrarily fixed zirithin the limits set by 
the Significance principle, as against any departure to a point 
outside those limits caused by a failure of competition or the 
intervention of illegitimate elements. For example, rent is not 
seldom driven above marginal Significance because of the ig- 
norance or inertia of tenants ; and government can then, with- 
out colliding with regular economic forces, bring it down to 
the proper level, (b) It is probable that there is nearly al- 
ways some leeway between the marginal Significance and the 
first submarginal one, in which case, our principle fixes, not the 
precise amount of each share, but only the limits within which 
it may range. But one point within these limits will reconcile 
supply and demand as well as another. Hence, within these 
limits, legislation can arbitrarily fix on one particular point 
rather than another, without coming into collision with regular 
economic forces. For example, if wages anywhere from $1.20 
to $1.40 would reconcile demand and supply, the law might 
fix them at $1.40, and not contravene our principle at all. (c) 
It is admitted that the prices of labor services or capital serv- 
ices or land services can be fixed at points somewhat outside the 
limits set by the Significance principle because of the inertia 
or weakness of buyers or sellers of those services. But this 
being true, it is surely reasonable to claim that government, 
when public policy demands it, can take advantage of similar 
weaknesses consciously to fix prices somewhat outside the lim- 
its set by our principle. 

2. Such arbitrary fixing of the economic shares is pos- 
sible only within very narrow limits. (2) Law can not long 
compel people to pay for anything more, — anyhow much more, 
— than it is worth to them, (b) Law can not long hinder 
people from paying for anything as much, — anyhow almost as 
much, — as it is worth to the marginal buyer ; for this is the only 
way to insure that buyers at or within the margin will get the 
goods, as against buyers outside the margin, (c) Law can 
not long compel people to furnish anything for a price much 



DISTRIBUTIVE PRINCIPLE: COROLLARIES 415 

below that which expresses to them the disutiHty incurred in 
furnishing that thing, (d) Law can not long hinder people 
from taking a price for their service substantially as low as 
that one which expresses the disutility incurred in furnishing 
said service. 

Corollary 2. Broadly speaking, the share per unit of each 
class of producing agencies varies inversely as the size of that 
class. 

Abundant land makes rent low ; abundant capital makes in- 
terest low ; abundant labor makes wages low. This obviously 
results from the joint action of our Significance principle and 
the law of diminishing marginal significance, page 261. Each 
productive agent tends to get an amount which expresses the 
significance of the contribution made by the marginal mem- 
ber of his class. But, since the larger his class the smaller will 
be the significance of the contribution made by the marginal 
member, therefore, the larger his class the smaller the income 
which each member will get. 

In saying this, as in stating any other scientific principle, 
we of course assume continuity of conditions. An increase in 
the volume of any factor would not necessarily lower the rate 
of return if accompanied by the introduction of new and more 
efficient methods of employing that factor. 

Corollary 3. Broadly speaking, the share per unit of each 
class of producing agencies varies directly as the size of other 
classes which co-operate with it. 

Increasing the size of one class of producing agencies in- 
creases the share of the others. For example, if capital in- 
creases in volume, not only does the rate of return to capital 
tend to fall, it is equally true that the rate of return to labor and 
land also tends to rise. The argument should be easy to fol- 
low. 

( I ) According to the last corollary, the condition supposed 
lowers the rate of return to the changing factor. (2) Since 



4i6 PRINCIPLES OP ECONOMICS 

the total going to said changing factor out of the product of 
earlier units of the combination is fixed by multiplying the num- 
ber of units into the rate, said total will be smaller than be- 
fore. (3) In consequence, the portion of the product of earlier 
units going to the other factors, being that product minus the 
total going to the changing factor, will be larger than before. 
Take a simple illustration. Ignoring capital, let us suppose 
that a certain piece of land will yield to one man's labor 14 
bushels of wheat ; to the labor of two men, 20 bushels ; to that 
of four men, 26 bushels. When, now, laborers are so few 
that land needs to be worked in the first stage only, the whole 
product, 14 bushels, will go to labor. When it becomes necess- 
ary to put on a second man, he will add only 6 bushels, there- 
fore will get only 6 bushels, and the first man also will get only 
6 bushels, thus giving the landlord 20 minus 12 or 8 bushels 
rent. So when a third man has to go on, his significance and 
so his share will be represented by 4 bushels; the shares of 
laborers i and 2 will fall to the same figure, and the total of the 
landlord will become 24 minus 12, or 12 bushels. Thus, in- 
creasing the number of laborers lowers their share and raises 
that of the landlord. 

That diminishing the size of one class diminishes the shares 
of the others, may be shown merely by reversing the preceding 
arguments. 

Corollary 4. Increase of population in itself tends to 
lozver all shares hut rent, most of all common zvages. 

This is really a sub-corollary from Corollaries 2 and 3. An 
increase in population means normally an increase in the size 
of all classes of producing agencies except land. Hence an 
increase in population would normally mean a diminution in the 
shares of all classes except those receiving rent. Further, 
this diminution would fall most heavily on wages for the rea- 
son that increase in population means a greater increase in 
labor power than in capital, that is, in the power to wait or as- 
sume the responsibilities of production. 



DISTRIBUTIVE PRINCIPLE: COROLLARIES 417 

In opposition to the teaching of this last corollary it is 
sometimes argued that increase in population does not lower 
wages for the reason that each person brings into the world 
capacity to produce as well as capacity to consume. He adds, 
therefore, to the supply of goods just as much as to the de- 
mand. This merely shows that there is not ordinarily any 
danger that the new laborer will be unable to get any wages 
at all. It does not show that he will be able to get as high 
wages as before. Since the stock of natural factors in produc- 
tion and the stock of capital are not increased by the incoming 
of the new laborers, therefore the marginal significance of 
labor, and with it the wages of labor, must tend to be lowered. 

Again, it is sometimes argued that increase in population, 
in that it makes a larger market and so justifies the resort to 
extreme specialization, large scale production, etc., really raises 
marginal significance rather than lowering it, and so raises 
the shares going to labor and capital. This is doubtless 
possible but not, in my opinion, probable. In most countries 
population has long since reached the size which would justify 
a resort to the most efficient methods. If a particular commun- 
ity is faihng to take advantage of the possibilities of large-scale 
production because markets are too small to justify a resort 
to that method, this smallness of the markets is probably not 
due to lack of the population necessary to make a large 
market, but to the lack of those facilities for transportation 
and communication in general which are necessary to coalesce 
the different small markets into one large one. 

Corollary 5. Any cause zvhich restricts competition among 
the persons zvho supply a particular type of service tends to in- 
crease the rate of income received by the said persons. 

It is of course a fact familiar to the student that producers 
in all lines are disposed to adopt measures to limit competition, 
each in his particular line. Monopoly in some form or degree 
is a condition of things which, consciously or unconsciously, 
almost every one tries to see realized in his special field. Per- 



4i8 PRINCIPLES OF ECONOMICS 

haps the entrepreneurs in some industry, for example, sugar 
production, form a trust, thus estabhshing a combination so 
wide-reaching as to approximate monopoly. Or perhaps the 
men engaged in building houses in a certain city form an 
agreement whereby they promise not to compete in the fullest 
sense against each other. Or perhaps the painters combine to 
restrict their numbers by refusing to take on more than a fixed 
number of apprentices at any one time. Now, it is doubtless 
hoped in each of these cases that the action described will in- 
crease the returns to the persons interested ; the entrepreneurs 
in sugar and the building contractors will get larger profits, 
and the workmen in the case of painting will get larger wages. 
Further, it it doubtless true that the result thus hoped for is 
largely realized. Such restrictions of competition do usually 
increase the incomes of the persons interested. The reasons 
are plain. Diminished competition means decreased output, 
therefore higher marginal significance, therefore higher price, 
for the service rendered. 

The principle, as stated, says "rate of income" rather than 
simply "income" in order to provide for cases where restrict- 
ing of output might increase the return per unit of service 
performed but not per person. Thus, the whole body of 
laborers might unite to keep, say, one-fifth of their number idle, 
hoping thereby to increase the total income of their class;* 
while in fact they might thereby lower the total though in- 
creasing the rate — that is, the income per unit of service or 
effort. 

Corollary 6. Any cause which restricts competition among 
the persons who supply a particular sub-class of services tends 
to lozuer the incomes of the persons zuho supply related sub- 
classes of services. 

*It probably can be shown that as a mere matter of economic 
theory this is a possible result. It does not, however, seem of sufficient 
importance to reward the effort. 



DISTRIBUTIVE PRINCIPLE: COROLLARIES 419 

As we have seen, it is very common to try to limit the out- 
put of one's own type of service in order thereby to raise the 
price of it. It is less common, but by no means rare, to hear 
persons who have inaugurated this policy attempting to enlist 
the sympathy and support of others as if the public in general 
or producers in general, were to gain by it. That persons 
sometimes succeed in this attempt does not alter the facts of 
the case. Their position is, generally speaking, quite unten- 
able. We may sympathize with their aims, may even be glad 
to suffer some loss in helping them to realize those aims ; but 
we are bound to experience a loss — the policy in question is 
against the immediate economic interests of all hut the persons 
directly concerned. 

The explanation of this fact in so far as it concerns related 
workers, should call for no elaboration. Restricting competi- 
tion within any sub-class of productive agencies, say painting, 
drives the persons shut out of that sub-class into related 
sub-classes, — carpentering, masonry, etc., — thereby increasing 
the size of said sub-classes. As a consequence, under the 
working of Corollary 2, the share per unit of those classes is 
lowered. 

Corollary 7. Broadly speaking, improvements in method 
through discovery and invetition tend more especially to in- 
crease interest and profits. 

Such improvements, by increasing opportunities for the 
employment of waiting and risk-taking, increase the marginal 
significance of those factors, and so fulfill the conditions of the 
Principle. This is not to say that improvements in method 
bring no advantage to laborers ; — but any advantage the lab- 
orer gets comes indirectly in lowered prices and in the greater 
quantity of goods which lower prices enables him to buy. 

As already noted, the disutility part of our principle is of 
much less importance than the significance part. Still it is not 
altogether negligible in practical affairs. In so far as any 



420 PRINCIPLES OF BCONOMICS 

class of persons depend for their income on supplying some 
primary factor which involves a disutility, we can not arbitrar- 
ily cut down that income without more or less interfering with 
the supply of that factor. This is the old story of killing the 
goose that lays the golden egg. One good reason for not inter- 
fering with the freely made price of a primary factor and 
the income derived from it is that only so can we be sure 
that the stock of said factor will be assigned to its proper tasks. 
But if the factor has a disutility cost, there is another reason 
for not interfering with its price and the income derived there- 
from, namely, that, by pursuing such a policy, we are liable 
to cut down the stock or output of the factor. This point may 
be formally stated in the following corollary. 

Corollary 8. // the primary factor from zvhich an income 
is derived has a disutility cost, all artificial attempts to reduce 
that income are likely to reduce the supply of said primary 
factor. 

I1.LUSTRATIVE Probi,]e;ms 

1. Suppose that at a certain date, competition being free 
and general conditions normal, the rate of wages for ordinary 
labor is $1.50 per day; and suppose, further, that, under these 
conditions, the legislature passes a law forbidding any one to 
pay or receive wages less than $5 per day. 

Do you believe that this would result in giving every one 
wages of $5 per day ? Why ? 

2. "The logic of their (the orthodox economists') teach- 
ing, has been that wages which were determined by free bar- 
gaining between capital and labor would be just or reasonable 
wages." 

Point out wherein the above is incorrect, or at least inade- 
quate, as a statement of the real teaching of the economists. 

3. Quite soon after her entrance into the war now being 
waged in Europe, Great Britain undertook to raise a large rev- 
enue by the exceptionally heavy taxation of the industries es- 
pecially connected with war, that is, the industries engaged in 
producing guns, ammunition, etc. What argument could be 
made against that policy? 



CHAPTER XXVIII 

RENT 

In Chapter XXVI we presented the general principle 
under which the four economic shares in distribution ais 
determined. In this and the three chapters following, we 
give a somewhat more detailed study to each of the shares 
taken separately. We begin with rent. 

I. The Nature of Rent 

As understood by the general public, the term rent com- 
monly means the consideration paid for the use of any tang- 
ible object, such as a house, a horse, a boat, an automobile, 
or a piece of land. Economic usage is much narrower, for 
it includes not hire in general, but only the hire of land. It 
does not include even the hire of buildings, fences, or other 
removable or impermanent improvements standing on the 
land. When trying to be very precise, indeed, it speaks of 
rent as derived from the original, indestructible elements 
only of land, excluding all improvements wrought by man, 
even those of the most permanent sort. As a matter of fact, 
this usage is not perfectly feasible for the reason that sorie 
improvements are so indestructible, so irremovable, so alto- 
gether permanent, that they become in effect inseparable 
parts of the natural thing itself. Thus a tile ditch laid in a 
field becomes once and for all a part of it; no one will ever 
take up the ditch, no one will need to give it more than an in- 
significant amount of repairs, and it will last indefinitely. 
Likewise the increased fertility of the land resulting from its 
drainage is a quality which, though originally created as an 
improvement, can never again by any probability be: extir- 
pated, so long as the land itself endures. In consequence, the 



422 PRINCIPLES OF ECONOMICS 

common practice is to interpret economic rent as paid, n',t 
only for unimproved land, but also for land improved in the 
ways indicated. 

The difficulty which is usually met in the way just in- 
dicated, is by some writers met by refusing to distinguish the 
hire of land from that of other goods, — calling them all rents 
or hires. This practice has not become general, and, in my 
opinion, is of doubtful expediency. The chief reason is that, 
in connection with certain problems of value determination 
and particularly in connection with the incidence of taxes, 
strictly non-producible goods, fixed-supply goods, behave in 
a quite different way from ordinary producible goods, and 
improved land behaves generally like the strictly non-pro- 
ducible goods. 

2. The Origin of Agricultural Rent 

The existence of rent, as the price of an economic good, 
is on the surface not difficult of explanation. Land is limited 
in amount, the uses of any one piece are limited in number, 
and hence the total number is limited ; land uses will, there- 
fore, command a price if there is a demand for it, at some 
price above zero, in excess of the stock. Further, since much 
of the land is inferior in quality or position, the demand for 
the uses of some pieces — the better ones — will exceed the 
supply long before the demand for all the uses of land has 
come to exceed the total stock. Hence uses of those better 
pieces will command a price. 

But, while the existence of rent presents nothing unusual 
or difficult of explanation, various reasons have led to the 
setting up of some very elaborate theories. These theories 
are not inconsistent with the general explanation given in the 
preceding paragraph, but merely more detailed and thor- 
ough. The statement for agricultural rent which best com- 
mends itself to the present writer may be called the Surplus 
theory. It runs as follows : — 



RENT 



423 



We begin with the hypothesis that all the land is of one 
grade, and that its productive efficiency is absolutely fixed. 
Such a hypothesis is, of course, in the highest degree unreal, 
but it will serve us best in bringing to light the essential 
cause we are seeking. At the outset, then, let us take for 
consideration the tract of land accepted by classical conven- 
tion, a small completely isolated island. On that island there 
are 1,000 acres of wheat land, each acre of which can pro- 
duce 30 bushels, no more and no less, at a cost of just 30 
cents per bushel, not counting any charge for the use of land. 
If all the land is used, the output will then be 30,000 bushels 
costing $9,000. 

Such being the technical conditions, let us now study the 
economics of the case. . Suppose that at a certain time the de- 
mand for wheat at 30 cents is only 2,000 bushels, while it 
falls to 1,900 bushels at 31 cents, 1,850 at 32 cents, and 1,800 
at 33 cents. With this demand schedule could there be any 
rent? No; for since the possible output of wheat (30,000 
bushels) is much greater than the demand at any price as 
high as cost (2,000 bushels), most of the land will not be 
used at all ; and the potential competition of the owners of 
the idle land will hinder the owners of the land under culti- 
vation from exacting any payment for its use. Again, under 
the conditions named, what will be the price of wheat? It 
will be exactly thirty cents. It cannot be lower, because at 
any lower price — which would be a price lower than cost — 
wheat would not be produced at all. It cannot be higher; 
for, it is possible at a cost of 30 cents to furnish more than 
is demanded at a price of 50 cents or higher, and hence 
competition of producers will hold price down to that figure. 
Finally, these two conclusions — the absence of rent and a 
price of 30 cents per bushel, — will still hold so long as, with 
price as high as 30 cents, demand can rise only to 30,000 
"bushels. 

But change slightly the hypothesis. Suppose that the de- 
mand increases, so that 31,000 bushels are wanted at 30 



424 PRINCIPLES OF ECONOMICS 

cents, 30,000 at 31 cents, 29,000 at 32 cents. Plainly, price 
will now advance to 31 cents; for only 30,000 bushels can be 
produced and they are all wanted at 31 cents. But, since cost 
is only 30 cents, this new price will give farmers a surplus 
over ordinary returns to industry of i cent a bushel or 30 
cents an acre. This surplus will naturally invite producers, 
who in other lines are getting merely the usual returns of 
industry, to offer to the land owner something for the right 
to use the land. The present tenant will raise the offer; the 
outsiders will come back with a higher bid; and so on till 
the competition of the two has caused the whole 30 cents to 
be turned over to the land owner. To assume that the land 
owner and the farmer are not different persons, that the 
land owner himself may work the land, does not alter the re- 
sult. Under the conditions set forth, price inevitably rises 
above cost of production, bringing into existence a surplus. 
This surplus is first received by the farmer, and it remains 
with the farmer if he is also land owner; while, if he is only 
a tenant, he is driven by the free working of competition to 
turn over that surplus to the one who is the owner. The sur- 
plus thus received by the farmer and retained by him if he is 
owner or, if he is tenant, turned over by him to the one who 
is owner, constitutes the economic share known as Rent. 

Looking back over this case, we see that the immediate 
cause of the rent surplus is the appearance of a price in ex- 
cess of the cost of production. But the cause of this higher 
price, and so the more ultimate cause of rent, is to be found 
in the fact that the demand for wheat at a price higher than 
cost is at least equal to the whole possible output ; or, put the 
other end to, in the fact that the possible output is no more 
than equal to the demand at some price above cost.* 



*A more common but less precise statement would be this : The 
ultimate cause of rent, under the conditions named, would be found in 
the fact that the demand for wheat at the cost price exceeded the 
whole possible ouput, or the whole possible output was smaller than 
demand at the cost price. This method of putting such cases as- 



RENT 425 

We have seen how rent originates in the very simple, but 
very unreal, case furnished by our first hypothesis. Let us 
now change the hypothesis so as to bring it a step nearer to 
the facts of life. Suppose that the wheat land of our island, 
instead of being all of one grade, is of four grades, though 
as before the output of each acre in each grade is absolutely 
fixed. There are 100 acres which will produce each 30 bush- 
els at a cost per bushel of 30 cents ; 200 acres which will 
produce each a little under 26 bushels at a cost per bushel of 
35 cents ; 300 acres which will produce each 22 ^ bushels at 
a cost per bushel of 40 cents ; and 400 acres which will pro- 
duce each 20 bushels at a cost of 45 cents per bushel. In 
each instance, greater expenditure will make no increase in 
output, while any smaller expenditure will produce no output 
at all. 

When would rent appear under these new conditions? If 
the demand for wheat were limited to 2,000 bushels, then, as 
in the previous case, there would be no rent ; since to produce 
that much wheat would require only two-thirds of the 100 
acres of best land, leaving the other third, as also all poorer 
lands, idle, and the competition of the idle 33 1/3 acres of 
best land would prevent any charge being made for the use 
of the 66 2/3 acres actually under cultivation. In like man- 
ner, the price would be, as before, just equal to cost, 30 
cents. Manifestly the same propositions would be true, 
were demand 2,100 bushels, or 2,200, or 2,300, or anything 
less than 3,000. But suppose, now, that the demand schedule 
becomes 2,100 bushels at 30 cents, 3,000 at 31 cents, and 
2,900 at 32 cents. At once price must rise to 31 cents; for 
the whole output which farmers can afford to raise so long 
as price is under 35 cents (3,000 bushels), is wanted at 31 
cents. But a price of 31 cents gives a surplus over cost of i 
cent per bushel or 30 cents per acre on the best land ; and 



sumes — which doubtless is commonly true — that a demand in excess 
of output at one price means a demand at some higher price equal to 
output. 



426 PRINCIPLES OF ECONOMICS 

this surplus, as in the former case, will be driven into the 
hands of land owners by the competition of possible ten- 
ants ; that is, rent will now come into existence. 

The explanation of rent is, moreover, virtually the same 
as before. The immediate cause is a rising of price above 
cost of production on the rent-bearing land. But the cause 
of that rising of price, the more ultimate cause of rent, is 
the fact that the demand at some price above cost is at least 
equal to possible output on the best land, or, turned about, 
that the output of the best grade of land is not greater than 
the demand at some price above cost. In short, it is the lim- 
ited stock and limited capacity, not this time of all land, but 
of land of the best grade, as compared with the demand for 
wheat, which causes rent. Land being of various grades, a 
scarcity of the best land makes itself felt in raising price and 
starting rent even though land as a whole cannot be said to 
be scarce. The existence of rent might thus be said to de- 
pend in a way on the fact that lands were of different grades. 
But the particular implication (in that statement) on which 
rent depends is that not all the lands are of the best grade, 
rather than "that there are inferior as well as superior 
grades." 

The above statement shows how, in our second hypothetical 
case rent would come into existence. But another fact concern- 
ing rent besides its mere exis'tence must now be noted. Let 
us suppose the demand schedule for wheat to advance by suc- 
cessive steps till a part of it reads as follows : 3,000 wanted 
at 36 cents, 3,100 at 35 cents, 3,200 at 34 cents. At first sight 
it might seem that price would now become 36 cents ; since 
3,000 bushels, the whole product of the best land, is now 
wanted at 36 cents. But a new element has come in. Ac- 
cording to the original hypothesis, there are 200 acres which 
can furnish each 26 bushels of wheat, a total of 5,200 bush- 
els, at a cost of 35 cents per bushel. By this time, price will 
have reached 35 cents, for 3,100 bushels are wanted at that 
price; consequently farmers can profitably work the 35 cent 



RBNT 



427 



land and will of course begin to do so. But, since 5,200 bush- 
els can be furnished off these second grade lands, the 3,100 
bushels wanted at 35 cents can easily be supplied at this 
price. Price, therefore, will stop at 35 cents, instead of go- 
ing to 36. 

Further, price would remain stationary at 35 cents, even 
were demand to increase so that there were wanted at 35 
cents 3,500 bushels or 4,000 or 5,000 or any number not 
greater than 3,000 plus 5,200. But, if price remains station- 
ary at 35 cents throughout all these changes in demand, then 
obviously the surplus over cost will also remain stationary, 
and therefore rent also will remain stationary. In short, the 
cultivation of the inferior lands acts to check rent; — the ex- 
istence of inferior land is not a condition on which the aris- 
ing of rent depends, — as is often said — but rather a condition 
on which the keeping of rent zvithin bounds depends. 

In the hypothesis just considered, we have already re^ 
stored one important fact of the real world — the variation 
in grades of land — which was purposely dropped out of our 
first hypothesis. Let us now restore another fact. Suppose 
that the possible output of each acre of land, instead of be- 
ing absolutely fixed, varies in some degree with the amount 
of expenditure. Further, with an expenditure of $9 each 
acre of land reaches the point of diminishing returns ; beyond 
this, increase in expenditure will for a time secure an in- 
crease in output but one less than proportionate to the in- 
crease in expenditure. Thus while $9 spent on the best land 
yields 30 bushels $12 would yield 38 bushels ; $15, 44 bush- 
els; and $18, 47 bushels; after which no increase is possible. 
Similarly for the second grade of land, while $9 spent on it 
yields 26 bushels, $12 would yield 32 bushels; $15, 34 bush- 
els; and $18, 38; after which no increase could be secured. 
And so on with the other grades of land. Under these con- 
ditions, as a little computation would show, when price 
reached 37 cents, output could be increased 800 bushels from 
the best land; when price reached 50 cents, output could be 



428 P RING IP LBS OF ECONOMICS 

increased 600 bushels from first grade land and 1,200 bush- 
els from second grade; when price reached 75 cents, output 
could be increased 800 bushels from second grade land and 
1,200 from third grade land. 

What will be the effect of these new conditions? Let us 
suppose the demand schedule to have advanced till a part of 
it reads as follows : 8,000 bushels wanted at 39 cents ; 8,5010 
at 38 cents ; 9,000 at 37 cents ; 9,500 at 36 cents. Under our 
former hypothesis, — that the productivity of each grade of 
land was absolutely fixed, — this demand schedule combined 
with the output schedule would give us a price of 38 cents. 
It could not be above 38 cents ; since this would cut demand 
down to at least 8,000 while as much as 8,200 could be fur- 
nished for 35 cents. It could not be below 38 cents ; for at 38 
cents 8,500 bushels would be wanted and only 8,200 could be 
furnished, and so the competition of the unsuccessful buyers 
would hold it at that point. But, while under the first hy- 
pothesis the new demand schedule would give us a price of 
38 cents, under the second hypothesis it would give a price of 
only 37 cents. For, when price reaches 37 cents we can, 
through the more intensive cultivation of the best land, in- 
crease output by 800 bushels, making a possible total at that 
figure of 9,000 bushels, — 3,800 from the best land and 5,200 
from the second best; and 9,000 bushels just satisfies the de- 
mand at 37 cents and so hinders a rise to 38 cents. 

Thus, the new hypothesis has hindered the price from ris- 
ing as high as it would have risen under the old. But any- 
thing which hinders price from rising thereby hinders rent 
from rising. That is, the more intensive cultivation of soils 
already in use checks the rise of rent. The principle that 
even after the stage of highest net efficiency has been reached 
output can be increased though at increasing cost per unit, 
furnishes a condition under which rent may be checked. In 
other words, the so-called law of diminishing returns — which 
might better be named the law of increasahle returns at di- 
minishing rate — in one of its phases furnishes a possible 



RENT 429 

check on the growth of rent; and from this standpoint takes 
its place along with inferior soils, the influence of which was 
■described above. 

The discussion just preceding has shown how the law of 
diminishing returns acts to check the growth of rent. We can 
hardly leave the matter without remarking emphatically that, 
looked at in another of its phases, this same law is a sine qua 
non of rent. The returns from the same piece of land are 
increasable ; hence a check on rent is possible. But the possi- 
ble increase is at a diminishing rate; hence, before the in- 
crease which checks rent can take place, price must rise 
above cost on the old plan of cultivation, and it is this rising 
which causes rent. If output could be increased indefinitely 
without any falling off in the rate, there could never be any 
rent; for supply would always keep pace with demand at 
cost price, — without any rising of price above cost. We could 
have rent, were returns absolutely fixed; we do have rent 
with returns fixed by an elastic limit, a limit increasable but 
at a diminishing rate; but we could not have rent, were re- 
turns indefinitely increasable without any falling off in the 
rate. 

We have set forth the process by which rent would come 
into existence under each of three different hypotheses, each 
being modified so as to bring it nearer to actual conditions 
than its predecessor. As a matter of fact, even the third hy- 
pothesis would differ from actual conditions in not a few 
particulars, and one difference at least is of sufficient im- 
portance to deserve special comment. In introducing the 
condition of gradations in land, it was assumed that the dif- 
ferent grades varied in productivity by considerable inter- 
vals. The best produced 30 bushels per acre ; the second best, 
26 bushels ; the third, 22 ^ bushels. But there can be little 
doubt that, in the actual world, lands vary in productivity by 
much slighter differences than these. Still keeping as near 
as possible to our original figures, the best land yields, let us 
■say, 30 bushels per acre ; the second grade 29 ; the third, 28, — 



430 PRINCIPLES OP ECONOMICS 

the differences being much smaller, though even yet very- 
likely too large. 

Does this new condition compel us to alter our explana- 
tion of rent? Not in any essential feature. To simplify 
matters, let us ignore the output per acre, and merely as- 
sume that, v^ithout pushing cultivation beyond the point of 
highest net efficiency, wheat can be raised on the different 
grades according to the following schedule : on the best, 3,^000 
bushels at a cost of 30 cents per bushel ; on the second grade, 
5,000 bushels at a cost of 31 cents; on the third grade, 7,000 
bushels at a cost of 32 cents a bushel ; — it being assumed al- 
so that people do not take account of differences smaller than 
a cent. How, now, would rent come into existence? Our 
previous answers fit easily enough. As soon as demand at 
some price above 30 cents equals or exceeds 3,000 bushels, — 
the output from the best land — price will rise above 30 cents, 
thus giving a surplus over cost which will be retained by the 
farmer if he is also land owner but which, if he is only a 
tenant, will be driven by competition from his hands into 
those of the land owner. 

But what part is played by the new possibilities of pro- 
duction at 31 cents, 32 cents, and so on? Just such a part as 
was formerly played by the possibility of production at 35 
cents. Since the output can be increased 5,000 bushels as 
soon as a price of 31 cents is established, then, although the 
demand schedule may be one which under the former hy- 
pothesis would have raised price to 32 or 33 or 34 or 35 
cents and so raised rent to corresponding heights, price may 
now be checked at 31 cents, and so rent kept at i cent a bush- 
el or 30 cents an acre. Thus, suppose the demand schedule 
to be: 3,500 bushels at 35 cents; 4,000 at 34 cents; 4,500 at. 33 
cents; 5,000 at 32 cents; 5,500 at 31 cents. Under our for- 
mer hypothesis, price would promptly rise to 35 cents, giving 
a rent on the best land of $1.50 per acre. But, under the new 
hypothesis, price could not rise above 31 cents, since at that 
price 8,000 bushels can be furnished and only 5,500 are 



RENT 



431 



wanted ; and rent could, in consequence, reach only 30 cents 
per acre. 

To summarize the above discussion: (i) The detailed 
process whereby rent comes into existence is as follows : de- 
mand at some price higher than cost becomes at least as 
great as possible output of best land cultivated to point of 
diminishing returns ; this causes price to rise above cost ; 
this gives to the farmer a surplus over ordinary returns; the 
existence of this surplus leads to the competition of possible 
tenants in trying to secure the use of the land by paying a 
price therefor; and this competition goes on till the whole 
surplus is turned over to the land owner as rent. (2) Bring- 
ing into cultivation inferior soils tends to check the rise of 
rent. (3) Cultivating more intensively soils already in use 
tends to check the rise of rent. 

3. Rent and Disutility 

In Chapter XXVI it was maintained that the disutility 
cost involved in supplying the three factors of human ori- 
gin, labor, capital, and responsibility-taking, had a part in de- 
termining their price. That price, we said, must be one 
which expressed both the marginal significance of these fac- 
tors in production, and the marginal disutility of supplying 
them. In other words the three distributive shares — wages, 
interest and profits — which constitute the prices paid for 
those three factors must express their marginal significance 
in production and their marginal disutility. But can the 
same be said of land, and the price of its services which we 
call rent? 

With regard to the disutility half of the principle, the an- 
swer is of course a negative one. In order to have a real 
disutility cost, a factor must be of human origin; hence land, 
which is not of human origin can have no disutility cost A 
particular piece of land may, like any other factor in produc- 
tion, have an opportunity cost. If it is needed for one pur- 



432 PRINCIPLES OF ECONOMICS 

pose and we desire to put it to another purpose, the advan- 
tage of the former will have to be sacrificed, and this fact 
will probably have a part in determining the price. But this 
sacrifice is not a true disutility cost. It follows that rent is 
determined solely by the significance or utility of land or its 
services. This significance or utility is probably for one rea- 
son or another more easily ascertained for land than for any 
of the other factors ; and so the significance or service-value 
principle is more fully realized for land than for labor, cap- 
ital, or responsibility-taking. But if land has no disutility 
cost, no disutility cost can influence its price. The disutility 
half of our principle has here no application. 

This matter, however, should not be left without further 
comment. While the furnishing of land services involves no 
original disutility, it does involve derivative disutilities. Un- 
der normal conditions, the market price of any piece of 
ground will approximately equal the capitalization of its net 
income. In consequence, persons desiring to become rent- 
receivers will be obliged to invest their capital in the land, 
just as if it were a producible commodity, — ^gaining the posi- 
tion of a rent-receiver will therefore mean assuming the or- 
dinary capitalistic disutilities, abstinence, waiting, and risk- 
taking. Further, this process of capitalizing the income of 
land will almost certainly work itself out in such a way that 
the income pretty closely expresses the disutilities created. In 
consequence, it might seem that we ought to affirm that 
rent must be so determined as to be an expression of the de- 
rived disutilities of supplying the land services for which it 
is received. This, however, would not be true. The disutili- 
ties follow rather than precede the appearance of the rent. 
Hence they have no share in determining the rent. It is 
rather the price of the land which must be so adjusted as 
to make the rent an expression of the disutilities involved in 
furnishing land services. 



CHAPTER XXIX 



INTEREST 



The subject of Interest has probably given rise to more 
theoretic analysis than any other part of Economics. This is 
due partly to the serious inherent difficulties of the subject, 
partly to the fact that such theoretic analysis, in the case of 
Interest, connects itself with certain great practical controver- 
sies. Of these controversies, the most important concerns the 
ethical legitimacy of interest. From the earliest times there 
has been much opposition to this particular source of income as 
being essentially immoral. This opposition, seeking to strength- 
en itself theoretically by showing that there are no valid 
grounds on which the existence of such an income can be just- 
ified, has devoted enormous energies to the study of the nature 
and origin of interest. Thus a purely practical problem has 
given immense stimulus to studies purely theoretical. It seems 
best, therefore, that we should here enter into some phases of 
the subject quite fully; though what we have to say will not be 
unfamiliar, since it has been, in great part, anticipated in pre- 
vious discussions. 

I. The Interest Phenomenon 

Our first task must be to develop clear and definite ideas 
of what interest is. Its most familiar manifestation is seen 
in connection with the ordinary money loan. A lender puts at 
the complete disposal of a borrower a sum of money; this 
money or an equivalent sum, is to be returned to the lender 
after a stated period ; and, in return for the advantages which 
are supposed to accrue to him from this operation, the borrow- 
er makes to the lender a special payment amounting to a small 
per cent, of the sum loaned and proportioned to the length of 



434 PRINCIPLES OF BCONOMICS 

time for which the loan runs. This special payment is of 
course the interest we are talking about. 

The type of interest just described is commonly called 
contractual, or, sometimes, explicit interest. It is open, avowed 
interest. But there are besides many business situations 
in which interest, though just as truly present, is more or less 
concealed — implicit interest. Consider for example the rela- 
tion between the prices of ordinary producible goods and their 
costs in other goods, current labor, and risk-taking. Each unit 
of product has a price high enough to cover not only the 
items just enumerated, but also interest on the invested capi- 
tal, — the sum of money which the entrepreneur could get from 
the sale of his whole outfit. This must be so, the business 
man would say, because otherwise no one would devote his 
money to manufacturing commodities ; instead, every one would 
lend it, getting contractual or explicit interest. 

This is inadequate if it is meant to be a complete explana- 
tion of interest; for sums of money are, so to speak, merely 
formal capital ; and the deeper explanation must be found 
in the inter-relations of those things which borrowed m^oney 
is used to buy rather than in money relations as such. But it 
contains this much truth : it is in the market for money-loans 
that the various forces which are causing interest to exist and 
determining its rate, most completely manifest themselves. 
Accordingly, the business man's method of arguing at this 
point supplies a clue which will often tell us where to look for 
implicit interest. Wherever we find a person occupying an 
economic relation which deprives him of an opportunity to 
make money loans and receive explicit interest therefor, we 
may be sure he is in some way receiving implicit interest. 

Illustrative Problems 

1. How does the interest phenomenon manifest itself in 
the price of a dwelling house? 

2. In the hire (rent) of such a house? 



INTBRBST 435 

3. In the price of a building site? 

4. In the fares charged by a steamship in the transatlantic 
passenger service? 

2. Essential Nature of the Interest Phenomenon 

The surface marks of the interest phenomenon have prob- 
ably been shown with sufficient distinctness in the preced- 
ing discussion. When, however, we inquire as to the real inner 
nature of interest we find ourselves beset with more serious 
difficulties. Out of a rather confused mass of writing on this 
subject we may distinguish two principal theories: the Use 
theory and the Exchange theory. 

The Use Theory is almost universal in the business world 
and has in former years been widely held by economists. Ac- 
cording to this doctrine, interest is a payment for the use of 
capital ; capital being conceived either as a sum of money 
or as money value embodied in some capital good. If a man- 
ufacturer borrows on his ninety-day note $600 to buy 200 tons 
of coal for his engines, he obviously gets all the uses of the 
coal but in addition he may be said to get a ninety-days' use of 
the $600 embodied in the coal. Similarly, if Mr. Elder buys 
a $1,200 automobile on a one-year note, he enjoys all the 
services which any cash buyer could realize from the machine 
and in addition he is thought of as having the use of $1,200 
for a year's time. 

In explaining the exchange theory, our best procedure per- 
haps is to begin by pointing out the fault in the use doctrine. 
No one denies, of course, that the borrower or the credit 
buyer gets some advantage, service, or utility, in addition to 
the services of the coal or the automobile; if he did not, he 
surely would not pay the interest. But the use theory, many 
thinkers affirm, errs in its method of characterizing this advant- 
age. The advantage of the man who buys goods with borrowed 
money or on credit consists, not in receiving a greater 
sum of utilities than the men who buy similar goods with 



436 PRINCIPLES OF ECONOMICS 

their own money or for cash, but in paying what is to him 
a smaller price. He enjoys all the prerogatives of a man 
who has acquired ownership in goods by the process of pur- 
chase, although he has not made the complementary sacrifice 
naturally involved in a purchase, — has not in the deepest sense 
bought the goods at all. In short, his additional advantage over 
the non-credit buyer consists in postponing the sacrifice neces- 
sary to becoming the rightful owner of the utilities of the 
goods. 

The CA- change theory as to the nature of interest will now 
be readily comprehended. Interest, it affirms, is in reality a 
bonus, a premium, a something to boot which the man who 
buys goods now but does not himself pay for them till some 
future time, gives to the person who enables him to effect this 
transaction. Or, looking at the operations from the lender's 
side, interest is a bonus or premium which the man who re- 
linquishes his right to goods now but gets his pay only at a later 
date, receives for making this exchange. To put the theory 
in more conventional form : Whenever present goods are ex- 
changed for future goods, a bonus or premium is paid by the 
party who brings to the exchange future goods, to the party 
who brings present goods; and this bonus or premium con- 
stitutes interest. Obviously, this description best applies 
to contract interest, where one particular kind of goods, es- 
pecially money, is borrowed with the understanding that just 
the same kind of goods is to be returned after a stated interval. 
But the advocates of this phraseology hold that it describes 
the real nature of every transaction wherein interest figures 
at all, even to the most obscure cases of implicit interest. The 
entrepreneur who buys raw materials, machinery, and labor, 
and combines these to produce shoes is in effect exchanging 
present for future goods; for the raw materials, machinery, and 
labor, though literally existing in the present, are not truly 
present goods, but only inchoate shoes, shoes in the making, 
shoes to be. 



INTEREST 



437 



Into the real merits of this controversy between the use 
and exchange theories, it will scarcely pay us to enter. In gen- 
eral, we shall assume that the antithesis between the two is 
not as great as their respective advocates imagine. The man 
who exchanges present for future goods must, as a condition 
of doing so, be in a position to wait, — he must have a surplus 
of wealth which, measured in value, equals the goods he ex- 
changes for future goods. Speaking figuratively, such a man 
must be the owner of waiting-power; and, this will usually 
be in the form of general wealth, — money or claims to receive 
money. To say that he sells the use of waiting power does 
not seem essentially different from saying that he exchanges 
present for future goods. 

3. How Interest Comes to Exist 

In beginning the explanation of interest, it is natural to make 
a remark similar to that with which we introduced the ex- 
planation of rent. Interest exists because the demand (at some 
price above zero) for a certain thing is in excess of the output 
of that thing; — in other words, because there is an extra- 
marginal demand for it. To explain the value of any object 
we have only to show that there are good reasons why there 
should be a demand for that object and good reasons why the 
supply should be limited. We are not called on to show that it 
must have value, but only to point out the conditions zvhich, if 
fulfilled, zvill insure, its having value. In the case before us, 
the thing commanding a price is the service of waiting. In gen- 
eral, then, our task is to show why there would naturally be a 
demand for waiting-power and why its supply would naturally 
be limited. 

Among the reasons why there would naturally be a demand 
for waiting-power are the following, (i) Overestimate of 
the importance of present wants (spendthrift borrowing), (2) 
anticipated increase in income, and (3) the superiority of time- 
consuming methods in the production of goods or services. 



438 PRINCIPLES OF ECONOMICS 

The first of these reasons needs little comment. Over- 
estimation of present as compared with future wants, the 
conviction that one's immediately pressing desires are import- 
ant above all things else and must be satisfied — this may be a 
foolish reason for borrowing, but it is plainly a very real one. 
The second reason is almost equally familiar. Many people, 
particularly the young, think themselves justified in borrowing, 
even if only to have a little more pleasure in the passing hour, 
because they confidently anticipate larger incomes in the near 
future. 

The third and perhaps the chief reason why there is a de- 
mand for waiting power has been alluded to in an earlier 
chapter. It is that, by using waiting-power we can make our 
productive efi^orts relatively more efficient. 

In trying to meet an immediately pressing need for shelter 
we may stop in the forest and with a few hours' labor build 
a hut of grass or boughs. But suppose that instead of try- 
ing to finish the shelter today for immediate occupation we 
make use of waiting-power and, in the course of a few weeks, 
erect a house of wood or stone. This shelter will consume 
not only waiting-power, but labor and resources; and it will 
consume perhaps ten or a hundred times as much labor and re- 
sources as the hut of boughs. But, because of the waiting 
element put into it, the length of service it will render will 
increase much more than proportionally to the increase in 
labor and resources consumed. Here then is an ex- 
cellent reason for choosing the method which consumes wait- 
ing-power. It enables us to take advantage of the solidity, 
hardness and durability of wood and stone and so, in the end, 
we have a house that will last five hundred times as long as the 
other type of structure, although it has cost us in effort and 
resources only one hundred times as much. 

Similar illustrations have already been cited. By waiting 
while he constructs a net and a canoe, the fisherman is en- 
abled in the long run to catch more fish per unit of labor ex- 
pended than he could if he began at once fishing with his naked 



INTEREST 439 

hands. The woodsman who makes an axe to cut down a tree 
and the miller who builds a dam and race for grinding flour 
similarly increases the efficiency of his labor. Still other cases 
are found in those types of production which are aided by or 
perhaps wholly dependent on some slow natural processes. 
Thus vegetables need a season to reach maturity; grape juice 
can be ripened into wine only through a series of years; it 
takes seedlings perhaps three quarters of a century to grow 
into trees fit for lumber. Our efforts to produce these things 
are thus not merely rendered more than proportionally efficient, 
they attain all their efficiency, they attain any degree of effici- 
ency whatever only by the application of waiting-power. 

There is, then, a very remarkable gain for productive effi- 
ciency in the use of waiting power. But this gain is one which 
every producer appreciates and which every producer is anx- 
ious to enjoy. Accordingly, to return to our main point, the 
opportunity to use more efficient methods which its possession 
gives us constitutes a third very powerful reason why there 
would naturally be a demand for waiting-power. 

I have dwelt on various reasons why there would naturally 
be a demand for waiting-power. It is equally easy to show 
that there would naturally be a limitation on the supply of 
such waiting-power. In the first place, the amount which a 
community could set aside for the future would of necessity 
always be limited by the total income; we could not conceiv- 
ably save more than the total product of our efforts. But, 
again, we could not by any possibility devote even this total 
product to providing for the future, for some of our pre- 
sent wants can go unsatisfied only at the cost of Hfe. Further, 
it would be folly to sacrifice any present needs for the sake 
of future ones which were not of equal importance. Ac- 
cordingly, a wise economy would never build up the stock 
of waiting-power for the satisfaction of future wants from 
that part of the current income which is needed to satisfy pre- 
sent wants of more, or even equal, importance. 



440 PRINCIPLES OP ECONOMICS 

The share of current income which can be devoted to the 
service of the future is further limited by the fact that future 
needs of a certain degree of intensity are not really as import- 
ant as present needs of the same degree of intensity. For 
this there are two reasons, (i) Life itself is uncertain; the 
present we have, the future may for us never exist. A per- 
fectly sensible and prudent person, therefore, will refuse to 
sacrifice a present want of a certain magnitude for a future 
one of the same magnitude. (2) Gratification of the present 
want is sometimes a condition necessarily precedent to the 
future want. Thus, the gratification of the present want may 
be essential to the continuance of life, or at least to the main- 
tenance of that degree of physical and mental health which 
alone can fit us for the enjoyment of the future gratification. 

But, even if present and future wants of the same magni- 
tude were equally important, we should still have a check on 
our processes of saving. This consists in the same tendency 
we have cited as a cause for the rise of demand for waiting- 
power; namely, the almost universal overestimate of the im- 
portance of present wants, the almost universal underestimate 
of the importance of future wants. For the same reason that 
borrowers borrow, savers are disinclined to save anything to 
lend them. Not to gratify the want of today seems an unbear- 
able hardship, while we contemplate without misgiving the de- 
privation of tomorrow. No doubt there are individuals to 
whom these remarks do not apply; some people accumulate 
much even with small incomes. But most of us spend freely 
or even carelessly; and, as a result, the supply of waiting- 
power accumulates less rapidly than it would if prudence in 
such matters were universal. 

We have thus shown why it is natural that there should 
be, on the one hand, a demand for waiting-power, and, on the 
other hand, a Hmitation of the supply. This does not prove 
that there must be interest. To prove that, we should need 
to show that the conditions tending to build up a demand 
for waiting-power and those tending to limit the supply of 



INTEREST 441 

waiting-power are so potent that they necessarily make the 
demand at some rate of interest above zero greater than the 
supply at that rate. To prove anything of this kind would 
be from the nature of the case impossible. However, as was 
pointed out in an earlier paragraph, we are not called on to 
undertake such a task. Our business here is to explain inter- 
est. This does not require us to prove that interest must ex- 
ist, but only to name the conditions ivhich, if fulfilled, will cause 
it to exist — and this we have clearly done. 

Illustrative Problems 

1. "That capital is productive has often been questioned, 
but no one would deny that tools and other materials of pro- 
duction are useful ; yet these two propositions mean exactly 
the same when correctly understood." 

Show that those persons who object to calling capital 
productive would hardly be satisfied with the above proof. 

2. Suppose that a fisherman could catch 21 fish a day 
without the aid of a net or boat or any other form of capital ; 
that to make a net would cost him thirty days' labor; and that 
it would last only thirty days. 

(a) What is the smallest number of fish which the net 
must enable him to catch each day in order to make it possible 
for us to credit any portion of the product to capital as capital ? 

(b) Supposing that the fisherman catches with the aid of 
the net 200 fish a day, what is the maximum productivity which 
could be credited to the capital as capital. 

(c) Under what circumstances would that maximum tend 
to be so credited to capital ? 

(d) Supposing that only 1,000 fish were actually credited 
to the net as its product, how would you explain the fact? 

(e) Can you imagine a condition of things under which no 
part of the catch would be credited to the net? 

3. In order that we should impute productivity to capital, 
is it necessary that some part of the capital supplied should 
have a cost of abstinence or waiting? 



442 PRINCIPLES OP ECONOMICS 

4. Interest and the Significance-Disutility Principle 

We argued in the preceding chapter that the economic 
share known as rent is with special ease brought into corres- 
pondence with the economic significance of the service rendered 
by land. We might almost as well have chosen interest as 
being peculiarly submissive to our principle. Almost every- 
where the capital market is especially free from interference, 
is especially characterized by freedom of competition. If, then, 
the reasoning of Chapter XX be accepted, — the reasoning 
that under complete freedom of competition the price of each 
primary factor inevitably tends to be one which expresses the 
marginal significance of that factor — we may be quite certain 
that this is true of interest, the price of the use of capital. 

There is, to be sure, probably no method of ascertaining 
directly and definitely the product-significance of a given unit 
of capital. Not a few writers believe such a method to exist, 
but I do not share their conviction. The economic significance 
of capital does not manifest itself in the same tangible way as 
does that of land. 

Nevertheless, the automatic process which we depended on 
in Chapter XX to make the prices of primary factors express 
their marginal significance here operates freely and fully. On 
every side opportunities arise for the use of capital in order to 
substitute machinery for labor. The advantage or disadvant- 
age of such siibstitntion turns finally on the rate of interest, 
the price of the use of capital. Entrepreneurs compete or re- 
fuse to compete for the supplies of capital according as its price 
does, or does not permit a profit on its use. So, the owners of 
that capital openly compete against each other to insure its 
employment. If its price exceeds its marginal significance, 
some portion of the supply will soon cease to be employed. If 
its price is below its marginal significance, marginal and intra- 
marginal users will have to bid up to shut out the extra-mar- 
ginal users. Entrepreneurs may be individually and collectively 
in complete ignorance as to the real marginal significance of cap- 



INTEREST 443 

ital ; but they have no difficulty ascertaining whether, at a given 
rate of interest, they can advantageously bid for more capital. 
Paying no attention to anything other than their own im- 
mediate profit, their spontaneous action finally brings the rate 
of interest to a point where it expresses the advantage of the 
marginal opportunity for the use of capital. 

Is the rate of return to capital governed also by the dis- 
utility principle ? Undoubtedly, as we have already argued more 
than once, the supplying of capital does necessitate some sac- 
rifice or disutility. The question remains as to whether the 
marginal portion of this sacrifice is expressed by the rate of 
interest. Doubtless a negative answer is possible. The volume 
of capital accumulation is influenced by other conditions than 
the rate of interest. For example, some persons are in a posi- 
tion to save from the present income without appreciable 
sacrifice while, at the same time, they desire to provide a sur- 
plus for the future. Such persons would accumulate capital 
even if they were obliged to pay for the privilege. It is, there- 
fore, conceivable that the amount of capital actually supplied to 
the market is not influenced to any great extent by a regard to 
the interest paid. . If not strictly a fixed-output good, it would 
have its fluctuations of output determined through forces 
other than cost. The price of its use, therefore, would not 
have to conform in any degree to the sacrifice of saving it. 

But, while this state of things is conceivable, it surely does 
not exist in fact. One type of accumulation, certainly, is mo- 
tived by considerations of direct economic gain. I mean the 
getting together of a small sum to make a start in business or 
speculation. Doubtless we are not here dealing with pure in- 
terest — ^the profit expected is the more important item. Still 
the interest problem is also present, since the entrepreneur who 
puts his own capital into a business can not help performing 
the zvaiting function as well as the responsibility taking func- 
tion. Now, Qxtry year a large amount of capital comes into 
existence in this way ; and it is hard to believe that such capital 



444 PRINCIPLBS OF ECONOMICS 

is wholly without influence in determining the rate of inter- 
est. 

But, finally, the accumulating of that portion of capital 
which is devoted to earning interest only must be materially 
influenced by the immediate reward in the shape of interest. 
Surely there are not a few people in such a position that they 
naturally say: The rate of interest has fallen so low that it 
really is not worth my while to save any more ; I would better 
enjoy the present. If so, their decision for or against further 
saving must change the volume of capital sufficiently to modify 
its price. Putting the matter in a still different way, can we 
seriously doubt that a fall in the rate of interest to zero would 
diminish the stream of new capital, or that a rise to ten per cent 
would increase that stream? If not, then we must say that the 
price of the use of capital must tend to express the marginal 
disutility of supplying it. 

5. The Rate of Interest and the Quantity of Money 

Besides the general theoretic questions respecting inter- 
est already considered, there are one or two of a more prac- 
tical sort which claim our attention. A very persistent and 
troublesome popular fallacy makes the rate of interest to vary 
inversely as the quantity of money; whereas of course the 
more ultimate causes determining interest are found, not in the 
demand and supply conditions of mere money, but in those 
of real capital, such as engines, machines, and lumber. This 
fallacy seems to spring from a popular confusion of money and 
capital. It is not unnatural in view of the fact that capital 
is always marketed in the immediate form of money or the 
money equivalent, bank credit. As a matter of fact, we may, 
in the long run, safely take as our guide to the interest relations 
prevailing among real capital goods, the market for mere money 
capital. But this is only because in the long run those interest 
relations prevailing among the real capital goods find full ex- 
pression in the market for money capital. In the actual de- 
termination of interest the quantity of money plays little part. 



INTERBST 445 

The argument is simple. What the borrower really wants 
is not money but goods, — engines, cars, rails, labor; and put- 
ting out more coin or more paper money will not make these 
goods cheaper to borrowers, nor will the withdrawal of money 
make them dearer. Or, if we suppose the rate of interest to 
be lowered at first b)^ an increase of money, the natural work- 
ing of things will soon reverse the movement, (i) The lower 
rate will lead to extensive borrowing and buying of goods. 
(2) This will raise the prices of goods; since they have not 
increased though the money has. (3) This will compel bor- 
rowers to borrow moj'e money in order to get the same amount 
of goods. (4) This will raise the rate of interest again to its 
former place.* Summarizing, we have the following Prin- 
ciple : 

Principle. In the long run, the rate of interest must he 
determined in substantial independence of the quantity of 
money. 

But, while in the long run we can not expect to influence 
materially the rate of interest by altering the quantity of money 
in circulation, we can for brief periods accomplish this result. 
In fact governments and powerful banks at times consider it 
one of their functions to manipulate the money stock for the 
express purpose of raising or lowering the rate of discount. 
Thus the Bank of England has in several instances contracted 
the circulation of London in order to force on the market a 
higher rate. The possibility of bringing about such results in 
the way indicated rests upon the following facts. 

Short-time loans largely connect themselves with the need 
for money, not to invest productively, but to meet money obli- 

*In fact, it is generally held that, when the stock of money is in- 
creasing, the expected fall in its value — rise in prices — will cause lenders 
to hold back for a higher rate of interest in order to insure themselves 
against loss on the principal. 



446 PRINCIPLES OF ECONOMICS 

gations. The demand is thus emphatically for money itself, 
not something which money will buy. Hence the short-time rate 
adjusts itself to the marginal utility of money capital, without 
much regard to goods capital. Emphasis rests also on the fact 
that the short -time rate adjusts itself to the marginal utility 
of money capital with little regard to the disutility of saving. 
This is simply the old case of short-time normals being de- 
termined without respect to cost of production. During a ser- 
ies of years, the price of wheat tends to equal its marginal cost 
of production. But between two harvests its price tends to 
be one which expresses the marginal utility of the existing 
stock. 

Principle. For short periods (a fezv weeks or months'), 
the rate of discount {interest) tends to equal that rate which 
expresses the marginal utility of the stock of money capital 
without much regard to the marginal utility of goods capital or 
the disutility of saving. 

IixusTRATivE Problems 

1. The law of 1900 for the better protection of the gold 
standard provided among other things that under certain cir- 
cumstances treasury notes (greenbacks) which have been re- 
deemed shall not be paid even in exchange for gold, but shall 
be hoarded, thus contracting the total currency. This was 
doubtless intended to protect the Treasury when a heavy gold 
export was in progress ; and, whether or not, it will doubtless 
tend to check such a gold export. Argue for the correctness of 
the statement after the semi-colon. 

2. At present the Imperial Bank of Germany has the un- 
conditional right to issue only 450 millions of uncovered (not 
backed by an equal amount of gold) notes; but, by paying a 
tax of 5 per cent on any excess over this amount, it may ex- 
pand the issue indefinitely. It is believed that this power can 
be used, and is used, to keep the rate of discount much more 
uniform than it would naturally be. Show that we can reason- 
ably look for such a result. 



INTEREST 447 

6. The Rate of Interest and Risk 

At any one time the rate of interest on capital used for the 
same general purpose differs greatly in different places, say 
Ann Arbor and Spokane ; and even in the same place at the 
same time it perhaps differs widely when the capital is put to 
different uses. The chief explanation of these differences is 
doubtless inequality in the matter of risk. The excess over, 
say, four per cent, in a given time and place may be conceived 
as an insurance premium, necessary to cover losses from bad 
debtors, or perhaps as a payment necessary to overcome the 
natural indisposition of the lender to take chances. If we un- 
derstand by "gross interest" the amount actually paid and by 
"pure interest" the rate to cover the simple use of capital, we 
may lay down the following principle, which though obvious 
and familiar, is unfortunately often overlooked. 

Principle. The atnount by zvhich gross interest in any 
particular case exceeds pure interest tends to vary roughly as 
the risk involved. 



CHAPTER XXX 

WAGES 
I. Wages and the Significance-Disutility Principle 

Of the general domination of the significance-disutility 
principle in the matter of wages, we need not speak in this 
place. In estabHshing the principle for the prices of primary 
factors, in chapter XX, the example of a primary factor 
which we used throughout was wages. Since the principle 
there established and the one now under discussion are es- 
sentially the same, anything which we should properly say 
about wages in the present connection may be found already 
set down in those earlier pages. It is only necessary, there- 
fore, to introduce a few minor points which might seem to 
modify the principle. 

To the effective working of the marginal significance 
half, there are two or three obstacles, especially if we have in 
mind the significance of the natural output of each type of la- 
bor service. In the first place, there is more or less restraint 
of competition on the part of those who supply labor: in a 
good many occupations, something like a labor monopoly ex- 
ists. Restriction is secured both by limiting the number of 
laborers in a given field and by limiting through various de- 
vices the natural output of those persons who do get into the 
field. As a result, the share of these persons tends to exceed 
that which would express the marginal significance of the 
natural output of their type of service. In short, society 
has to pay for many of the higher services more than would 
be expected in view of the amount of those services which 
would naturally be forthcoming. Laborers who supply the 
services get more than they earn, using the latter term in its 
ordinary sense. 



WAGES 449 

We need not, however, take this concession too seriously. 
In this age of pubhcity, free education, and universal initia- 
tive, few combinations could, in the long run, be successful in 
shutting out the competition of the really fit. Further, the 
policy of the trades unions is to some extent — though cer- 
tainly not a large one — offset by an analogous procedure on 
the part of employers. Adam Smith, the so-called father of 
Political Economy, said that there always exists a universal, 
though tacit, combination among employers to keep wages 
down. This was probably nearer the truth in his day (1776) 
than now. The vastly greater extent of the market within 
which labor is bought and sold now makes tacit combination 
almost impossible ; and formal combination for this end seems 
not to have been carried far. Still there is probably enough 
to offset in some measure the monopohstic combinations of 
labor. In short, it is probably safe to assume that the wages 
of even the higher forms of manual labor are not priced at 
a point materially above their natural marginal significance. 
Another obstacle to the complete domination of wages by 
the Significance principle is the lack of mobility among la- 
borers. We have all noted that the mere competition of sell- 
ers will not secure the advantage of buyers unless the latter 
are themselves reasonably alert. A shop may advertise ever 
so conspicuously the fact that it sells the same wares at prices 
below those of its rivals ; but, unless buyers note the fact and 
act accordingly, they will not benefit from the favorable com- 
petition. But the converse proposition is also true. The mere 
competition of buyers will not insure good prices to sellers 
unless the latter are alert enough to become cognizant of the 
fact, and are in a position to profit by their knowledge. Ig- 
norance, lack of means, inertia — by all of which laboring men 
are too frequently hampered, — may tombine to neutralize 
more or less completely the advantage which they might de- 
rive from the free competition of employers. 

Another reason often given for expecting wages to be dif- 
ferent from what they would need to be to express the mar- 



450 PRINCIPLES OF ECONOMICS 

ginal significance of labor, is that wages in many fields are 
fixed by custom. Thus we have been wont for years to pay 
housemaids $3 to $4 per week in one social class, $5 to $6 in 
another, $7 to $10 in another. Similarly, the wages of common 
labor range usually from $1 to $1.50 per day. Now, without 
doubt, custom has some direct influence on the rate of wages ; 
but that influence is, in the opinion of the writer, much ex- 
aggerated. In the first place, the facts do not display the de- 
gree of uniformity claimed. Within a few years a very marked 
change in the alleged customary standard has taken place. 
The amount which we commonly assume will have to be paid 
for one or another type of labor has changed three or four 
times in the memory of living men. Again, the uniformity 
claimed is not exact enough to show the effect of custom. 
Custom is nothing if not fairly inelastic. A custom which 
permitted men to wear at a formal dinner anything from a 
frock coat to a doctor's gown would not be called a custom at 
all. So, a custom which makes wages for one type of service 
range from $3 to $4 a week can hardly be called a custom. 
Again, if wages were so much under the influence of cus- 
tom, we should see but little change in their rate due to in- 
flation of the currency, rise in the value of the standard, im- 
migration, booms in business, and other modifying condi- 
tions. But statistical investigations have shown that wages, 
though moving somewhat slowly^ do actually move in re- 
sponse to changed conditions. Finally, the considerations not- 
ed a few paragraphs back, publicity, general education and 
universal initiative, create a strong presumption against the 
belief that in our day mere custom can exert a marked influ- 
ence in wage-determination. 

We have, finally, to remark a tendency rather pronounced 
with some present-day writers to put forward the influence 
of bargaining in the determining of wages as a reason why 
wages can not, and do not, express marginal significance. 
These writers usually set out with the idea that the sole 
downward limit of wages is what the laborer will take, much 



WAGES 451 

as the upper limit is what the employer can afford to pay. 
They thus overlook altogether the part played by ejnployers 
in fixing another possible lower limit to wages, and hence 
insure that the supposed lower limit shall be a very low one 
indeed, one leaving ample room for bargaining. But this 
analysis is certainly unsound. There is another lower limit* 
besides what the laborer will take, namely, the significance 
of labor to the first extra-marginal employer ; and this limit 
is often much higher than the employee's minimum, so that 
the range of bargaining is much narrowed. Further, a good 
deal could be said for the contention that the laborer's mini- 
mum which really appears most of the time is the wage he 
believes he can get elsewhere ; it is not a true laborer's mini- 
mum but rather a minimum set by the extra-marginal em- 
ployer. 

Generally speaking, then, bargaining does not act upon 
wages with the force recently attributed to it, and does not 
displace in any marked degree the principle of marginal sig- 
nificance. In so far as our principle is displaced by bargain- 
ing, this is probably true, not because bargaining as such can 
override the natural limits set by the marginal and first extra- 
marginal significances, but because the bargaining is, on one 
side, collective, monopolistic. The individual employer has 
to deal, not with each workman, nor even with his workmen 
as a unit, but with the trade ; and the trade as a totality has 
restricted competition in one way and another so that bar- 
gaining can move wages outside the limits set by the marginal 
and extra-marginal significances of the natural output. But 
this was already provided for in admitting that monopolistic 
labor could set limits other than those which would be es- 
tablished by the marginal significance of the natural output. 



*Oddly enough, the analysis is usually inconsistent at this point; 
for it does not ignore the part played by employees in fixing an upper 
limit which may be under that fixed by employers. 



452 PRINCIPLBS OP ECONOMICS 

2. Wages and the Standard of Living 

In an earlier connection, it was held that, under a regime 
of free labor, the supply of laborers is not, to any great ex- 
tent, directly regulated by economic motives. We should not, 
however, assume a total lack of connection between the size 
of the laboring population and economic conditions. While 
there is, probably, very little direct regulation of the size of 
laboring men's families, yet through both conscious and un- 
conscious processes, population tends so to adjust itself that 
the typical rate of wages is compelled to coincide roughly 
with the workingman's conception of zvhat is essential to a de- 
cent living. This, of course, means merely that the result 
named is effected in the long run. Laborers cannot raise their 
wages here and now merely by deciding that more is needed 
to insure a decent living. At any moment their numbers are 
fixed; and comparatively few will take to the road for the 
difference between $1.50 a day and $1.40 a day. Their wag- 
es, therefore, must for the moment roughly correspond to the 
marginal significance of their labor. But a given standard 
of living insisted upon through a series of years will express 
itself in diminished population ; this, in the end, will raise the 
marginal significance of labor; which, finally, will raise wages 
to the required height. 

A very practical application of the above principle is seen 
in the fact that the rate of wages can be altered by chang- 
ing the ideals of the wage earners. Adverse conditions may 
permanently lower actual wages, because those adverse con- 
ditions may hold wages below the old standard of Hving un- 
til the working classes have insensibly come to accept a new 
inferior standard. On the other hand, favorable circumstanc- 
es may work the opposite result. In short, a new level of 
wages brought about, and for some time maintained by tem- 
porary causes, tends to persist. 

The points brought out above may be formulated in the 
following Principle and Corollary. 



WAGES 



453 



Principle. Under the natural working of economic and 
social forces, the long-run rate of wages tends to he that rate 
which will enable the working classes to maintain that stand- 
ard of living which, in the particular time and place, is looked 
on as necessary to a decent living. 

Corollary. In the long run the rate of wages can he al- 
tered by changing the ideals of the working classes as to 
what is essential to a decent living. 

IlvIvUSTRATiVS PrOBLKMS 

1. What bearing does our principle have on the question 
whether Chinese immigration should, or should not, be dis- 
couraged ? 

2. "No remedies for low wages have the smallest chance 
of being efficacious, which do not operate on and through the 
minds and habits of the people." Mill. 

Argue for the truth of this statement. (It probably needs 
qualification; but leave that for some other occasion.) 

3. Argue that, though the restrictive policy of the trades 
unions temporarily injures lower classes of workingmen, in 
the long run it is likely to raise wages generally. 

3. The Theory of Employment 

One aspect of the wages problem which has the greatest 
practical importance for every one is Employment. The most 
fundamental and inclusive law indirectly governing employ- 
ment has already been expounded, under the title of Say's 
Law. Accordingly, we need do no more in the present con- 
nection than briefly restate the principle and derive a few sig- 
nificant corollaries. 

a. Employment and the Demand for Products 

Immediately, of course, labor is bought by entrepreneurs ; 
and so, in a sense, the amount of employment depends on the 
demand of entrepreneurs. But entrepreneurs do not want 



454 PRINCIPLBS OF ECONOMICS 

labor save as they intend to produce goods with it and they 
are not going to produce goods save as the public demand 
them. Less immediately, therefore, the amount of employ- 
ment is determined by the public's demand for goods. But as 
we learned from Say's Law, the public's demand for goods is, 
in the last analysis, dependent on their ouput of goods. Only 
by producing goods can we create a demand for the goods of 
other entrepreneurs and, therefore, only by this process can 
we create a demand for the labor of the workmen who assist 
those other entrepreneurs. These facts may be formulated 
as follows : 

Principle. In so far as employment depends on the de- 
mand for products, it changes with, and only with, the out- 
put of products for the market. 

Corollary i. The destruction of objects of wealth which 
are hound to he replaced does not increase employment. 

A second set of facts with regard to which people often 
hold erroneous ideas will appear in the following: 

Corollary 2. Private expenditure for extravagances, as 
contrasted "with other forms of expenditure or even with 
hoarding, does not increase employment. 

Ten thousand dollars spent in buying bread or cotton 
cloth contributes just as much to make a demand for labor 
as $10,000 spent in buying fireworks or champagne. Ten 
thousand dollars spent in buying 500 ounces of gold coin to 
bury in the ground contributes to the demand for labor just 
as much as $10,000 spent on gold for plate. It is true, of 
course, that some forms of expenditure give more employ- 
ment than others, since labor, as compared with capital and 
land, is used more extensively in some forms of production 
than in others. But economists have with practical unanimity 
held that expenditures for extravagances contribute less to 
create employment than those for capital goods. 



WAGES 



455 



The effect of hoarding on the labor situation is chiefly of 
theoretic interest. Temporary hoarding may diminish the 
demand for labor, since without causing an increased demand 
for gold, it does diminish the demand for other things. But 
true hoarding is in our day a negligible phenomenon. The rich 
man nearly always spends his money (or lends it to some- 
one who spends it) whether for consumption goods or for 
those devoted to production. 

Corollary 3. Governmental extravagance does not in- 
crease employment. 

The truth of this corollary should naturally be inferred 
from the one above. Of course governmental extravagance 
may temporarily increase employment in a period of indus- 
trial stagnation when hoarding, as suggested in the preceding 
paragraph, has tended to diminish it. But in general we ma}'- 
say that the money which the government spends has to be 
taken from tax-payers ; and if left with the tax-payers \i 
would be spent by them personally to buy goods, and so make 
as much employment as when spent by the government. 

Corollary 4. Producing for oneself, when it is done 
without decreasing one's output for the market, does not di- 
minish employment. 

For example, a person who produces through his prop- 
erty or his efforts or both, say, $1,000 worth of products each 
year does not diminish employment by putting in some spare 
time building himself a boat. Assuming that his outside pro- 
duction is not changed, his demand for goods on the market 
is the same as before, and therefore creates the same employ- 
ment. 

Corollary 5. Broadly speaking, an increase in the sup- 
ply of labor services creates opportunities for employment as 
well as absorbing them, though not usually in quite the same 
proportion. 



456 PRINCIPLBS OP ECONOMICS 

This proposition is not so evident as the preceding; nor 
can it be accepted without larger qualifications. But it is still 
substantially true. If the whole producing group creates a 
demand for labor by producing, it follows that the labor part 
of the producing group creates a demand for labor by its 
producing. Doubtless it must be admitted that not all the de- 
mand created by labor's production will eventuate in a de- 
mand for other labor; since labor's demand for goods will be 
a demand for all the factors necessary to produce those 
goods, land and capital services, as well as labor services. But 
with the majority of commodities, the contribution of labor, 
direct or indirect is by all odds the most important element. 

There is no intention here of asserting that the process de- 
scribed will have no adverse effect. Without doubt it will tend 
to cause some decline in the rate of wages, under the working 
of the principle of diminishing marginal significance. But 
this result is not to be confused with the question of employ- 
ment. 

b. Employment as Dependent on the Supply of Land 
and Capital 

In carrying forward the preceding discussion, it was as- 
sumed that, in demanding goods, the public create an almost 
equal demand for labor, and, so create an almo^st equal 
amount of employment. But this presents only a partial view 
of the matter, since production requires other factors besides 
labor. A demand for goods cannot constitute a demand for 
the labor needed to produce those goods, unless there are land 
and capital available to complete the combination.* 



* It is, of course, equally true that a demand for goods does not con- 
stitute a demand for the land necessary to produce those goods, unless 
there are available labor and capital to complete the combination. So a 
similar affirmation may be made with respect to capital. In short, in a 
sense each kind of productive goods constitutes a demand for the 
others. 



WAGES 



457 



There is also another reason for affirming the special de- 
pendence of labor for employment on capital. Besides supply- 
ing the produced materials and instruments of production, 
capital commonly performs another function, namely, ad- 
vancing the ivages of current labor. Doubtless in some cases 
wages are not advanced at all and in others they appear not 
to be advanced, since the workman is paid only at the end of 
the week or month. But, from the standpoint of the entrepre- 
neur they usually are advanced, in the sense that a large part 
of the wages paid during any particular week or month are 
paid for labor which is devoted to producing incomplete 
goods, — goods which will give money returns only at a later 
period. Because of this fact production requires a waiting 
additional to that involved in supplying the necessary mate- 
rials and instruments. In short, production requires some- 
where in the community a fund of circulating capital suffi- 
cient to supply the current wants of producers. As a large 
part of its function will be to make advances to laborers, it 
may well be called the wage fund. 

Without question the classical economists for a time push- 
ed too far the doctrine that employment and wages are de- 
pendent on capital, developing a special theory of wages, 
known as the wage-fund theory. According to this doctrine 
in its cruder form, there is at any moment a fairly determinate 
sum of capital devoted to the purchase of labor services, so 
that, unless the number of workmen changes, no change in 
the average of wages can be made, — an increase to one class 
being offset by a corresponding decrease to some other. In 
practical application, this theory was made to prove the futility 
of strikes and the doctrine probably did not deserve much con- 
sideration. Still, its fundamental truth cannot be denied. Em- 
ployment is more or less dependent on a special section of cap- 
ital, reasonably enough called the wage-fund. 

As a rough summary of this discussion, we may lay down 
the following: 



458 PRINCIPLES OP ECONOMICS 

Principle. Broadly speaking, satisfactory opportunities 
for employment vary with the abundance of natural resources 
and capital. 

c. The Limits of Possible Employment 

In the preceding discussion we affirmed the reciprocal de- 
pendence of land, capital, and labor for opportunity. Rigidly 
interpreted, this doctrine would suggest that there is a definite 
limit to the opportunities of each of these factors, — or, for 
our special purpose, to those of labor. Given a certain 
outfit of natural resources and capital, there will be opportu- 
nity to utilize a definite amount of labor and no more. Such 
an interpretation would nicely support the popular notion that 
there are just so many jobs, no more and no less, so that 
giving a job to one person necessarily takes one from some- 
body else. To the trained economist, this view seems quite 
unwarranted. But possibly our present discussion may have 
given it some color of sense. Does not the affirmation that 
land and capital, as well as labor, are essential to production 
support the contention that labor opportunities are strictl}; 
limited ? 

In answering this, we have to remind ourselves that all 
industry is, during some period, in the condition of Returns 
Increasable at Diminishing Rate. That is, even if the availa- 
ble quantities of land and capital are constant, yet increasing 
the amount of labor will increase the total return to the com- 
bination though not proportionately. Since the increase in 
return is the contribution in the product which will be credited 
to the additional labor, and, as such contributions will deter- 
mine the price of labor, it follows that the new conditions 
will lower wages. Still, this will not alter the fact that the 
new labor has found employment. Accordingly, we may say 
that, under ordinary conditions, no one need lack employment 
if he is content to accept that wage which expresses the new 
marginal productivity of labor. 



WAGES 459 

As a basis for the foregoing argument, it was said that, 
during some period, industry is in the condition of returns in- 
creasahle at diminishing rate. But this basis does not al- 
ways hold, and so the principle laid down calls for quali- 
fication. It is possible that industry should reach a stage 
where its returns are substantially fixed, where they have 
reached their maximum: — even if the efforts of another la- 
borer could increase the output somewhat, still the additional 
amount would be so small that even with the extremest con- 
ceivable economy it would not furnish subsistence. Employ- 
ment is so far dependent on land and capital, and the possi- 
bilities of industry are so limited that a time is akaays liable 
to come zvhen opportunities for employment cannot experi- 
ence any measurable increase, when no^more laborers can be 
utilized. 

Further, in actual life the practical, effective limit to em- 
ployment is usually reached somewhat short of the combina- 
tion of maximum returns. The decline in the marginal pro- 
ductivity of labor does not go on till men could live on no 
less. Rather it stops where they will live on no less. In ear- 
lier times conquering migration and, more recently, peaceful 
emigration have brought relief ; and in our own day improve- 
ments in methods of production have repeatedly pushed far 
into the distance the point of maximum returns. 

d. Employment as Affected by the Rivalry of Capital 

Capitalistic methods are generally labor-saving methods, 
hence methods which in themselves decrease the need for la- 
bor as compared with the need for capital. Capital there- 
fore appears in some sense the rival or competitor of labor. 
This fact has naturally given rise to much controversy as to 
whether the introduction of improved methods does not di- 
minish the total demand for labor, (i) All are agreed that 
immediately certain classes of laborers suffer by being thrown 
out of employment and compelled to make new adjustments. 



46o PRINCIPLES OP ECONOMICS ■ 

(2) Experience shows that, in any given industry taken as 
a whole, there is Httle, if any, decrease in employment ; be- 
cause the lowered price due to lowered cost so stimulates de- 
mand that the old workers are needed to meet that demand 
even under the new and more efficient methods. (3) The 
lowered price due to lowered cost, if it does not create new 
demand, releases buying power saved because of the lower 
price, which will be spent on new products, save on the al- 
most inconceivable hypothesis that goods have become so 
abundant and their marginal utility so low that people, no 
longer want more things. But supplying these new products 
will furnish employment opportunities for the labor displaced 
in the old industries. 

These last remarks would not show that the introduction 
of improvements has no tendency to lower wages by making 
labor relatively more abundant and so lowering its marginal 
utility. We are here concerned only with opportunities for 
employment at some wage or other. 

e. Employment and Foreign Trade 

One of the most obstinate of popular fallacies is the no- 
tion that the employment opportunities of the people of a 
community are diminished by carrying on trade with other 
communities, that buying outside takes away jobs from one's 
own people. Against this notion economists have always 
protested. The principle given below is a mere corollary from 
the Principle of Reciprocity discussed in Chapter XIII. For- 
eign trade is necessarily reciprocal. If we are buying abroad, 
we must be selling abroad, — must be delivering the foreigner 
some form of wealth, either goods or money. But, in pro- 
ducing the commodity or commodities with which we pay the 
foreigner for our purchases, we create opportunities for em- 
ployment just as truly as we should by producing the imported 
goods at home. There are some valid arguments for artificially 



WAGES 461 

developing certain industries within our own borders ; but this 
"more employment" argument is not one of them. 

Principle. Broadly speaking, changes in the extent to 
zvhich goods are bought abroad has no effect on the amount 
of employment.* 



*Remember that in this, as in any principle of science, all conditions 
other that the one under consideration are assumed to be unchanged. 
For example, we must not suppose that, when we stop buying certain 
things abroad, there is an inflow of capital from abroad. Such a pro- 
cedure would be introducing a change in conditions other than a mere 
decline of foreign buying. 



CHAPTER XXXI 

PROFITS 
I. The Real Nature of Profits 

In the business world, profits though usually confused with 
interest, were early recognized as a special share in distribu- 
tion. This recognition was present also in the earHer theoretic 
discussions. The Medieval churchmen, who sweepingly con- 
demned interest — usury as they called it, seem to have con- 
sidered profits legitimate, — meaning by profits a share going 
to the capitalist who undertook the risks of enterprise. But, 
after economics had come to have some scientific development, 
profits largely failed, especially among the English and Amer- 
ican writers, to receive any distinct and separate treatment. 

Even when in the middle of the last century, the office of 
the entrepreneur began to get attention from English econo- 
mists, there was a singular failure to recognize his true func- 
tion. He was represented as primarily the man who man- 
aged productive operations. And this happened in countries 
in which industry was rapidly passing into the hands of en- 
trepreneurs who hired men to manage their business rather 
than doing it themselves. This doctrine still shows a most 
astounding tenacity in the texts, though it is manifestly quite 
untenable. The peculiar function of the entrepreneur must 
surely be found in something which he only can do, which he 
can not hire someone else to do. For anything coming under 
the latter category is plainly labor. Now, the only functions 
which seem necessarily to be left with the entrepreneur, are 
the assuming of final responsibility and performing certain 
types of management which can not be delegated, for exam- 
ple, appointing those who shall direct the business. 

Profits, as the term is frequently used by the general pub- 
lic, include the whole net return to the responsible owner of a 



PROFITS 463 

business after money outlay has been deducted from money 
receipts. This whole return, which we might call Gross Prof- 
its, usually includes at least three elements, (i) wages of some 
sort, principally for management, (2) interest on capital in- 
vested, and (3) a remuneration for taking the responsibility 
of production, and making certain final decisions which neces- 
sarily fall to the owner. 

The first element has come to be eliminated from profits 
even in the popular sense of the term because of the great ex- 
tension of the corporate form of business in which the work 
of management is turned over to hired officials. The second 
element,, interest, is still commonly included. That is, stock- 
holders in a concern paying seven per cent, dividends would 
think of the business as yielding seven per cent, profit, rather 
than four per cent, interest plus three per cent, profit. In this 
sense, profits is contrasted with interest in being the return 
to the capitalist who bears the zvhole burden of ownership, 
waiting plus responsibility-taking ; while interest is the return 
to the capitalist who assumes only one part of the burden, 
waiting. In strict economic analysis, however, profits ought 
to be limited to the third element, the taking of responsibility 
and making final decisions. From this point of view, profits 
in the illustration above would be only three per cent., the dif- 
ference between what the capital would have received if lent 
to the company and what it actually did receive as invested in 
the business. Profits in this sense, we will call Pure Profits 
or Profits Proper. 

Pure Profits, then, are the remuneration for responsibility 
taking, especially for the risk element in responsibility-taking. 
They include an infinitesmal amount of wages, in that the own- 
er must make certain final decisions — though in practice this 
tends to become negligible — and perhaps other disutilities or 
sacrifices. But the chief element in the case is the bearing of 
economic risk. 

That risk for the bearing of which profits are paid must 
not be confused with the regularly recurring, calculable losses 



464 PRINCIPLES OF ECONOMICS 

of a business. Such losses simply increase the outlay for la- 
bor and capital goods. The remuneration received by the en- 
trepreneur because of such losses would never be thought of 
as profits, but only as a fund to replace costs. The risk for 
w^hich profits are paid is the risk of losses which cannot be 
recotiped in the experience of the individual entrepreneur, — 
risks of total failure, or some loss almost as great. Compare 
the breakage of bottles in the brewery business with the 
chance that temperance legislation will destroy the business. 
The former is covered by greater outlay. The latter is a not- 
to-be-compensated loss. To induce men to assume the risk of 
such a loss, they must be paid something, not of course enough 
to cover the loss if the risk should become a certainty, but 
enough to move their wills to face the possibility of loss. It 
is thus evident that profits must not be conceived as a con- 
tribution to an insurance fund from which losses are covered. 
There is no such fund ; the losses are not covered. 

Under Socialism, the sort of risk now remunerated by 
profits would in the main be covered by an insurance fund ; 
since the state, having a complete monopoly of production, 
would pool in its own hands all risks, and, as well, all chances 
of occasional gain. The risk cost of production, therefore, 
except perhaps in the case of long time enterprises under- 
taken for future generations, would become simply more capi- 
tal and labor cost, instead of being as now, the price of the 
psychological disutility of bearing risks. It is probable that 
the state would charge each commodity with the average cost 
of the whole output of that commodity, including successful 
and unsuccessful branches of the industry involved. Profits, 
as an element of cost, would not therefore be entirely elimin- 
ated under socialism, but would appear in another guise. 

2. Do Profits Tend to Disappear 

A noteworthy fact in recent economic discussion is a dis- 
position to hold that profits — pure profits — ^tend to disap- 
pear. The argument for this contention moves along two 



PROFITS 



465 



general lines, (a) It is affirmed that pure profits, assuming 
them to be paid for risk-taking, will necessarily disappear 
with the elimination of risk from industrial aifairs; and such 
ehmination is steadily proceeding through the increase of 
knowledge, forethought, and invention, (b) Secondly, it is 
claimed that the disutilities correlated to profits are disutili- 
ties which plenty of men, especially in America, are quite 
willing to assume without reference to an economic reward. 
The desire for power, the craving for better social standing, 
and the gambling spirit which eagerly improves the opportu- 
nity to take chances, — all these unite to m.ake men willing to 
undertake the responsibilities of production, even though they 
expect to get nothing more than ordinary interest on their 
capital and ordinary wages for their labor. 

In reply to the first of these arguments, it seems sufficient 
to declare that the complete disappearance of risk, chance, un- 
certainty from industrial affairs, if not quite impossible, is 
certainly so remote that it cannot properly be made the basis 
for any affirmations with respect to the present order. Some 
centuries hence we may have become able to predict the weath- 
er for a year in advance with absolute precision ; but we 
shall still have to reckon with the uncertainties due to hu- 
man folly and caprice. The second argument is less easy to 
answer, yet will not, I think, carry conviction to most per- 
sons. The first two motives named, the desire for power 
and the desire for social position, affect only a small minority 
of our entrepreneur class, namely, the small individual or 
partnership entrepreneurs, who combine in themselves the 
functions of capitalist, manager, and entrepreneur. For most 
of our entrepreneurs, belonging to that class merely by vir- 
tue of being stockholders in some industry organized as a 
corporation, enjoy neither power nor prestige. Under the cor- 
porate organization of industry, salaried officials are the ones 
who wield power and the social position of capitalists (bond 
holders) is surely as good as that of stockholders, assuming 
their investments to be equal. But, if there is any large sec- 



466 PRINCIPLES OF ECONOMICS 

tion of the entrepreneur class with whom these non-economic 
motives would not suffice, — who would insist on a greater 
economic return for taking responsibility than for simply 
lending their capital — then, profits would surely have to be 
paid. 

The third consideration, — the gambler's desire to take 
risks — contains the old confusion of ideas which has already 
been commented on more than once. It is undoubtedly true 
that men are so ready to take risks, when a possible prize 
is in sight, that they do not as a whole class have to be remu- 
nerated for taking that risk. If all the copper producers of 
the world spend 500 million dollars worth of labor and capi- 
tal getting out the product, it is not necessary that the product 
should be worth 500 millions plus something for the risks 
taken. On the contrary, that product will probably be worth 
less than its labor and capital cost, say 400 millions. But all 
this is beside the point. The real issue concerns, not the whole 
class of entrepreneurs interested, but only those upon whose 
conduct depends the output actually supplied, the successful 
entrepreneurs. Do these persons have to get profits? Surely 
they do, else there would not be this gambler's eagerness to 
assume the risks of the business. The proper test for de- 
termining whether profits as a remuneration for risk-taking, 
really exist, is this : Does society have to pay a higher price 
for a given commodity or service than it would have to pay 
if risk were eliminated? Surely there can be but one answer 
to that question, the affirmative one. 

3. Profits as Affected by Changes in the Value of 
Money 

In an earlier discussion, it was shown that the value of 
money itself may change, and, so, general changes in prices 
may take place without reference to the conditions ordinarily 
governing the value of each commodity. Thus, under the pa- 
per money standard of Civil War times, there was a general 



PROFITS 467 

rise of prices, or, in other words, a fall in money, in the United 
States. So, for many years following 1873 there was a gen- 
eral, though gradual, fall in prices, — a rise in money, — affect- 
ing most or all of the Western nations. Much more rapid 
ups and downs mark the periods immediately preceding or 
following commercial crises or panics. 

There has naturally been much debate as to how far such 
movements influence all shares in distribution and particularly 
profits. At first thought one is inclined to say that of course 
such changes influence profits. If a merchant has paid $100,- 
000 for a stock of goods and because of a universal and simul- 
taneous fall in prices, their value declines to $60,000, how can 
anyone deny that the merchant is losing $40,000? This sounds 
plausible, but is in fact an undoubted fallacy. A universal 
and simultaneous fall in prices of 40 per cent, raises the buy- 
ing power of $60,000 till it is just as great as was the value 
of $100,000. Assuming, then, that no other element was in- 
volved, the merchant in question would neither gain nor lose 
as a result of the general fall in prices. That fall in prices 
does not of itself mean a fall in profits. 

The above affirmation was qualified by the assumption that 
no other element was involved. But in actual life this condi- 
tion is seldom fulfilled. In the first place, the merchant is 
usually carrying on his business in greater or smaller meas- 
ure with borrozved capital. But the sum which he has prom- 
ised to pay when borrowing does not change because the 
value of money has changed. If he is using $20,000 of bor- 
rowed capital, he will have to pay back, not three-fifths of 
that sum — $12,000 — but the whole $20,000. His debt has not 
shrunk though the value of his goods has. To pay his debt 
he will need so much of his goods as are now worth $20,000, 
which means so much of those goods as were worth five-thirds 
of $20,000, or $33,000. Hence he has lost the difference be- 
tween $20,000 and $33,000, or $13,000. It follows that, in 
so far as the dealer works upon borrowed capital, a change 
in the value of money causes an inverse change in his profits : 



468 PRINCIPLES OP ECONOMICS 

if the value of money rises he loses proportionately, and if 
that value falls he gains proportionately. 

Another element in this situation which compels a quali- 
fication of our original statement is that general price move- 
ments do not take place at an equal rate all along the line. 
Some goods rise or fall more rapidly and more promptly than 
others. In particular, wages do not change as rapidly as gen- 
eral goods. It follows that a rise in prices, — a fall in the value 
of money — is likely to redound to the advantage of the deal- 
er, in that he gets a larger return from the sale of his goods 
while his expenses for labor have not proportionately in- 
creased. And of course a reversal of the situation, that is, a 
general fall in prices, an increase in the value of money, works 
to the disadvantage of the dealer for precisely opposite rea- 
sons. 

4. Profits and the Significance-Disutility Principle 

The attempt to establish the validity of our Significance- 
Disutility principle for each of the economic shares meets the 
greatest difficulty in the case of profits. As already explained,, 
we mean by profits proper the return going to the man who 
takes the responsibility of ownership. We usually distin- 
guish several dififerent sorts, the nature of which is perhaps 
sufficiently indicated by their names. The most important are : 
Ordinary, Enterprise, Speculative, Monopoly, and Accidental 
profits. 

One has no difficulty showing that profits are in some 
sense or degree correlated to a service rendered, a signifi- 
cance in economic relations belonging to the part performed 
by the receiver of the profits. Further, profits are undoubt- 
edly in some sense or degree proportioned to the significance 
or magnitude of the service rendered. Thus, all must admit 
that those persons who initiate a commercially dubious, but 
socially important, enterprise perform a greater service than 
those who carry on the same in later years when success is 
assured ; and, undoubtedly, the profits must commonly be 



PROFITS 469 

larger for the former persons than for the latter. But, ad- 
mitting a rough correspondence between profits and the serv- 
ice rendered, it does not seem possible to affirm quite the same 
degree of correspondence as in the case of wages, interest and 
rent. 

Where profits are accidental, the correspondence between 
services rendered and reward received is of course slight. 
Such profits do not tend to express the marginal significance of 
the receiver's contribution. 

Monopoly profits doubtless correspond rather closely to 
the marginal significance of the supply of service actually 
rendered, but not to the marginal significance of the supply of 
service which would naturally be rendered. The monopo- 
list, by limiting the output of his product raises its marginal 
utility, and so its price, above the marginal utility which the 
product would naturally have. In doing this, he obviously 
raises his own profits above the amount which would express 
the marginal utility of his services, were no limitations set on 
their output. 

One qualification must, however, be added. The monopo- 
ly which temporarily exists may have been anticipated, and 
may have been one of the necessary conditions which induced 
capitalists to undertake the industry in question. Hence we 
may say that the monopolistic output is after all the nat- 
ural one and so that monopoly profits comes fully under the 
service- value principle. Cases of this sort are supplied by the 
legal monopoly of patents, copyrights and franchises, and by 
the quasi-monopoly of new enterprises. Here the extra prof- 
it does not correspond merely to the higher valuation by su- 
pra-marginal buyers of the service rendered, but also to the 
additional service. For, surely, there is an additional service 
when men undertake to try out the feasibility of a new en- 
terprise, — giving the public an opportunity to see the real 
utility of the service or commodity which the enterprise sup- 
plies. 



470 PRINCIPLES OF ECONOMICS 

Yet in spite of this qualification of our first statement, 
economists are not generally disposed to affirm the service- 
value principle for monopoly. The presence of monopoly at 
any point more or less seriously interferes with the realiza- 
tion of the principle. Hence, assuming for the moment that 
the principle is a good one in an economic order, then monop- 
oly, if necessary or permitted, ought to be regulated or con- 
trolled in the public interest. This point, however, will re- 
ceive fuller treatment later on. 

The argument for Enterprise Profits has been more or less 
anticipated in the preceding paragraphs. Such profits some- 
what resemble prises. Many persons get nothing; a few get 
large rewards. Under these conditions, we can scarcely ex- 
pect profits to express with great precision the contribution of 
the profit-receiver. Yet we should not, on the other hand, 
imagine that the two are entirely divorced. Opportunities for 
exploiting novel enterprises are constantly arising; competi- 
tion for such opportunities is kept fairly brisk ; the goods pro- 
duced must command prices expressing their marginal utility ; 
the marginal contributions of the other factors are at the same 
time being more or less fully determined in other fields ; and 
it seems not unreasonable to assume that the residuum of 
product — 'which constitutes profits — is properly credited to the 
entrepreneur as his contribution. 

That Ordinary Profits, if they exist at all, tend to ex- 
press the marginal significance of the entrepreneur's contri- 
bution, seems .to need no further discussion. Here the ele- 
ments of change and uncertainty are reduced to a minimum ; 
so that the economic processes which tend automatically to 
secure each factor a share representing its contribution to the 
joint product, meet little hindrance. 

We have seen that the Significance half of our principle 
does not very clearly dominate profits. How about the Dis- 
utility part? It seems plain that disutility would have little 
influence on Accidental or Monopoly profits. Ordinary prof- 
its, however, it would seem, must express with fair precision 



PROFITS 471 

the marginal disutility of supplying the entrepreneur service. 
First, the demand of the public must insure for a product a 
price high enough to cover the disutility undergone by the 
entrepreneur; since otherwise production w^ill cease, supply 
will fall off, and so price will rise. Second, the competition 
of entrepreneurs will keep price from going higher than the 
above point; since their numbers can be recruited at all times 
from those capitalists who merely furnish waiting power, 
who lend their capital rather than invest it. 

In the case of Enterprise profits, also, correspondence be- 
tween the disutility and its reward seems necessary from the 
same reasoning, though here the correspondence is less pre- 
cise. The objection is sometimes raised that there is too much 
chance in these cases to insure any particular result. Thus 
the price of a product may fail to cover, not only the peculiar 
disutility of the enterpreneur, but even the ordinary outlay for 
material, wages, and capital ; while on the other hand, it may 
cover all that outlay and give a surplus large enough to in- 
sure almost any conceivable risk several times over. This 
reasoning quite fails to recognize the real nature of the re- 
sponsibility-taking disutility. It consists not of a chance of 
loss to be covered by insurance, but of a chance of loss not 
to be covered at all. To induce men to incur that disutility, a 
prize or bonus, of larger or smaller magnitude, must be at- 
tainable in the event of success. The size of that bonus is 
roughly proportioned to the risk, though the unit of variation 
is very different for different races ; and, having been fixed, 
it must be covered in the price of the product. 



CHAPTER XXXII 

INCOMES AND FORCES OUTSIDE THE GENERAL 
DISTRIBUTIVE PRINCIPLE 

We have thus far dealt with incomes as determined solely 
by the Significance-Disutility Principle. But other forces 
are of course acting upon incomes in a way to alter appre- 
ciably the facts heretofore set forth. Incomes are affected by 
non-economic forces ; they are affected by the distribution of 
property ; they are afifected — or our attitude toward them is 
affected — in a high degree by our appreciation of the distinc- 
tion between apparent and real income. Let us glance briefly 
at these points in order, 

I. Incomes as Affected by Non-Economic Forces 

We have seen that incomes generally, and the inequalities 
of incomes, are determined by the laws of value or price, that 
is, by strictly economic forces. But no one doubts the con- 
stant operation of other forces, some of which work to di- 
minish the inequality natural to our freely competitive or- 
der, others to increase it. Among the non-economic forces 
tending to diminish inequality, we have all sorts of em- 
ployers' philanthropies, profit-sharing, co-operation, a vast 
system of charities, and large endowments to meet all 
sorts of needs. Over against these, intensifying the in- 
equalities natural to the present order, we have a great array 
of powerful forces, predatory competition, favoritism, breach 
of trust, nepotism, stock- jobbing, frauds of all kinds, and so 
on. But, though admittedly influential, these forces do not 
properly fall within the limits of our present study. Rather, a 
purely scientific analysis of economic principles assumes their 
complete exclusion. The extent to which they modify our 
principles in actual life may reasonably enough be left to the 
discussions of ethics or sociology. 



INCOMES: OUTSIDE FORCES 



473 



2. The Distribution of Property 
Three of the four economic incomes, profits, interest, and 
rent, are derived from property. It follows that back of the 
determination of incomes, immediately considered, must lie 
the distribution of property. We understand the theory of 
these incomes only in part, if we stop with the study of them 
at the point where they are given off by land and capital. We 
ought to go deeper and explain the distribution of ownership 
in land and capital. It will be impossible to do this at all 
fully in the present course, but a few comments will help us 
to get a fairly adequate view of the general situation. 

a. First, in so far as possessions are derived from one or 
more of the four regular incomes, large properties can be 
built up only through saving. In this respect there has been 
no change from primitive times. Thrift is still the essential 
condition of acquiring great possessions. With fortunes well 
started the exercise of thrift does not of course involve great 
privation, it does this only when accumulation is at its be- 
ginning. But, whether causing privation or not, thrift, in the 
sense of keeping within one's income, must always be be es- 
sential. Wanton extravagance can never consist with the 
building of great fortunes. 

It should perhaps be remarked in passing, though we can- 
not linger to discuss it, that in our day one particular kind of 
income — profits — rather than the others, has, when economi- 
cally used, been especially effective in the creation of great 
fortunes. This is using profits quite broadly to include all 
gains which go to the people who assume the risks of owner- 
ship : (a) profits derived from the exploitation of stores of 
natural wealth, (b) profits from the exploitation of new in- 
ventions, (c) profits from monopolies, partial or complete, 
(d) profits from unearned increments, increases in values 
due to changes for which the owners of the properties in 
question are not responsible, and (e) profits from industrial 
reorganization. The great size to which some of these kinds 
of profits are frequently swollen will be sufficient explanation 



474 



PRINCIPLES OF BCONOMICS 



of why, with thrifty use, they should originate large property 
holdings. 

b. In the second place, the maintenance of great for- 
tunes must always depend in considerable measure on the 
practice of thrift. This does not mean serious privation of 
any sort, but only a firm adjustment of expenditure to in- 
come. Reckless extravagance can dissipate the greatest of 
fortunes. This fact has usually been accounted a sufficient 
safeguard against the dangerous concentration of wealth made 
possible through inheritance. The extravagance of heirs, it 
is argued, can always be depended upon to dissipate extra- 
ordinary wealth in one or two generations. But this tendency 
has probably been a great deal overestimated. It would not 
be difficult to point out families which, by the exercise of rea- 
sonable thrift, have retained wealth for several generations 
and bid fair to continue the experience. 

c. Inheritance always has played, and still plays, a very 
great part in determining the distribution of possessions. Ob- 
viously its significance is chiefly dependent on the particular 
laws and customs which obtain in any time and place, (a) In 
earlier times, entail was used to maintain an unequal distri- 
bution of property; law, or custom as binding as law, prohib- 
ited the breaking up of estates by alienation through sale or 
gift, (b) Where entail is no longer permitted, settlement 
may accomplish something like the same result ; though recent 
legislation has attempted to provide for the practical nullifica- 
tion of such settlement, (c) Primogeniture, exclusive inherit- 
ance by the oldest child, is still the order of things with the no- 
ble families of England, and, of course, tends to perpetuate the 
existing inequalities more than would subdivision among sev- 
eral children, (d) In contrast with entail, settlement, and 
primogeniture, the democratic ideal as represented by mod- 
ern France insists on equal division among the children. This 
is no doubt a great improvement, assuming that the tendency 
toward inequahty is undesirable, (e) In these later years, 
still other influences are coming into play. If the significance 



INCOMES: OUTSIDB PORCBS 475 

of inheritance is, as we said, dependent on prevailing laws, the 
tendency of present day legislation is to diminish that sig- 
nificance, in to to. The particular instrument used is the in- 
heritance tax. This has already been developed to a very 
considerable magnitude and is everywhere being carried fur- 
ther. In Great Britain, it amounts to nearly 10 per cent, in 
the case of direct heirs and to about twice as much for the 
more remote collateral heirs. 

d. In the United States one of the chief sources of great 
fortunes is the public — governmental — grant. Under head- 
ing "a" above, it was said that profits derived from the 
exploitation of stores of natural wealth were largely instru- 
mental in building up fortunes. But the opportunity to ob- 
tain such profits naturally rests on the ownership or control 
of land and the latter in turn has largely been obtained through 
governmental munificence or folly in granting such land. 

Here, those interested in moral issues might declare, we 
have one of the greatest abuses in American industrial evo- 
lution. We have squandered the patrimony of many genera^ 
tions. The weakness of government in a new and republi- 
can nation, a careless over-estimate of our resources, preoc- 
cupation of each with his own afifairs, — these and other condi- 
tions have combined to make possible a reckless profligacy in 
the disposition of our natural resources which future genera- 
tions will find it hard to comprehend and still harder to for- 
give. On the other hand, it might be argued that in some 
measure public liberality has been justified as part of the 
price of our extraordinary rapid development. The justice 
of government grants, however, is not our present concern. 
We are only interested in the fact that, right or wrong, such 
grants have been the source of a large proportion of Ameri- 
can fortunes. 

e. There can be no doubt that fraud of varying kind and 
degree has been an important factor in determining the dis- 
tribution of possessions. Here we have in mind, not the fraud 
which enlarges income and which would therefore make pos- 



476 PRINCIPLES OF ECONOMICS 

sible the enlargement of possessions, but rather the fraud 
which directly adds to possessions, for example, getting con- 
trol of valuable timber lands belonging to the state by illegal 
means. Under the preceding head, we noted the absurd lib- 
erality of government in turning over public property of in- 
calculable value to private persons for little or nothing. The 
evils of such a policy have been increased in no small degree 
by fraudulent practices. By the collusion of legislators and 
public officers, the patrimony of the state has been stolen on 
a gigantic scale. Quite as notable, perhaps, has been the steal- 
ing of franchises yielding hundreds of millions. In the lesser 
relations of ordinary business also, fraud has played no in- 
considerable part. Swindling of partners, freezing out weaker 
stockholders, violating trusts, etc., are constantly practiced, 
and constitute a very potent factor in determining the owner- 
ship of large properties. 

3. Real vs. Apparent Incomes 

Up to this point in our discussion of incomes, we have 
ignored altogether the possibility of a discrepancy between the 
seeming income and the real one. But a very little reflection 
will show that there is such a possibility. In the great ma- 
jority of cases, apparent incomes are in the form of money, 
while real incomes consist in the sum of goods, other than 
money, which we may actually enjoy. But there is not, neces- 
sarily, any exact correspondence between these two. For, 
first, though money incomes are used to purchase our real 
incomes, yet the buying power of money may be, and surely 
is, very different in different places and in the same place at 
different times. Further, to get the really effective income 
which a man enjoys, as such words are generally understood, 
various other additions or deductions have to be made, even 
if we have made allowance for the differences in the purchas- 
ing power of money. These discrepancies between apparent 
and real incomes we shall now briefly discuss. 



INCOMES: OUTSIDE FORCES 477 

a. Income as Affected by Prices 

Any cause which tends to change the prices of particular 
goods tends thereby to change the incomes of all consumers of 
such goods other than those consumers who are also produc- 
ers of said goods. 

One of the most familiar appHcations of this is found in 
monopoly. The greatest significance of monopoly, as modi- 
fying distribution, is in that, by raising prices, it reduces the 
volume of our real incomes. Another illustration is the in- 
direct tax which, by adding to the outlay of the producer, 
causes price to rise, and so lowers the real incomes of those 
who purchase the goods. (A noteworthy feature of this case 
is the fact that a tax on imports makes a higher price, not 
only for the imported part of the goods consumed, but also 
for the part produced at home.) Still another important 
cause of this sort is improvement in methods of production; 
for these reduce costs of production and selling prices and, 
consequently, increase the effective income of purchasers. 

Again, if for any cause there is a change in the general 
level of prices, this fact is likely to modify more or less the 
real incomes of people. 

Some pages back we pointed out that changes in the gen- 
eral price level are likely to affect favorably or unfavorably 
one sort of income, — profits. The process there mentioned di- 
rectly affects money income. But such changes in general 
prices may also modify real, as compared with money, in- 
comes. A general rise in prices obviously lowers the buying 
power of a given income. Now, if at a time when the buy- 
ing power of money is falling, particular money incomes re- 
main absolutely or relatively fixed, the corresponding real in- 
come must certainly be reduced. The worst sufferers in this 
situation are annuitants, pension-receivers, and persons de- 
pending on contractual interest for their incomes. Next come 
the persons whose income consists of fees, and salaries, which, 
if not legally fixed, are anyhow slow to change. The case 
of wage-earners is hardly less serious; since the rate of wages 



478 PRINCIPLES OF ECONOMICS 

responds only with difficulty to changing conditions. Thus, 
the upward price movement consequent upon the paper money 
inflation of the American civil war reached its maximum for 
commodities in 1865, but for labor the date was 1872. 

b. Incomes as Affected by Taxation 

It is evident that, if, after a man has come into possession 
of his money income, government either directly or indirectly 
takes from him some portion of that income, his final income 
of gratifications of the ordinary sort is thereby curtailed. This 
must not be understood as implying that payments to govern- 
ment are in no sense correlated to a real income to the tax- 
payer. The expenditures of government are surely of advan- 
tage to the citizen; and, for some purposes, the citizen ought 
to think of his contribution to that expenditure as a thor- 
oughly legitimate and important part of his personal budget. 
Still, we cannot rationally describe payments to government 
as the purchase price of services rendered, in the sense that 
we use these terms when speaking of payments to the grocer 
or the drygoods dealer. It is quite impossible to form any 
rational theory of the ethics of present-day taxation except by 
recognizing that taxes constitute a contribution which it is our 
duty to make, and the government's duty to exact from us, 
in order that certain general, public ends may be accomplished, 
— ^ends in which it is often extremely difficult to trace the 
personal advantage of the tax -payer. For our present purpose, 
therefore, it seems legitimate to look on taxation as cutting 
down our real incomes. 

Starting from this viewpoint, we find that taxation tends 
to modify somewhat the distribution which would naturally 
result from the free, spontaneous working of economic forces, 
but to modify it less, on the whole, than one might expect. 
In fact a system of taxation which continued substantially 
unchanged throughout long periods would probably have al- 
most no modifying effect on distribution. Such a system 
would simply become established as one of the fundamental 



INCOMES: OUTSIDE FORCES 479 

conditions under which the service-value principle would work 
itself out ; wherever a tax might fall originally, it would be so 
shifted as to bring about the same relative distribution as 
would have prevailed without it. But, however this may be, 
we all know that systems of taxation cannot^ and do not, re- 
main unchanged for indefinite periods. Further, when a new 
tax is levied, its shifting in the manner indicated is not an 
easy matter which can be accomplished in a few months or 
even in a few years. Rather it may consume the life of a gen- 
eration. This being true, it is important to ascertain some of 
the effects on distribution which will be produced at the out- 
set, and, if desirable, guard against them. 

It is usually admitted, for one thing, that indirect taxes, 
such as import duties and excises, if levied in a way to be 
greatly productive, fall with relatively greater weight on 
small incomes than on large ones. The reason is that taxes 
of this sort, to be effective in raising the billions required by a 
great nation, must be levied on the fundamental necessaries of 
life. If they were levied on luxuries, the people of small in- 
comes would escape payment, but the total returns would be 
insignificant as compared with governmental requirements. 
On the other hand, taxes levied on salt, woolen fabrics, to- 
bacco and other goods of universal consumption, can usually 
be depended on to fill the treasury. But, of the fundamental 
necessaries the poor man must buy from his thousand dollar 
income almost as much as the rich man buys from his hun- 
dred thousand dollar income. It follows that such a tax falls 
with much greater weight on the poor man than on the rich 
one. 

Again, a general property tax afifects the incomes of per- 
sons owning visible property much more than the owners of 
bonds, stocks, etc. Buildings, land, live-stock, furniture, and 
equipment of all kinds are bound to pay an undue proportion 
of a property tax; for, being visible and tangible, they are 
easily assessed at something near their real value, and their 
location is fixed, so that they cannot "dodge." The owners of 



48o PRINCIPLBS OF ECONOMICS 

stocks, bonds, mortgages, and other intangible property have 
innumerable ways of concealing or disguising their holdings 
until the assessor has passed. They can also claim residence, 
and therefore the location of such properties, in some place 
outside the region of high assessments. 

Finally, a land tax of long standing does not constitute a 
burden on any private income. Suppose a tax is imposed on 
a piece of land, and, afterward, the owner decides to sell it. 
Prospective purchasers will now capitalize the value of the 
tax, and subtract this value from the price v/hich they would 
pay for the land untaxed ; in other words, the value of the land 
falls by such a sum as, at the probable rate of interest, will 
pay the tax in perpetuity. Thus, by a backwardation process, 
as it is called, the first man who sells a piece of land after a 
tax is levied on it really pays the whole tax. Or, to put it in 
another way, the government becomes, in effect, a part owner 
of the land, an owner in the proportion represented by the 
amount which was deducted when the land was sold. The 
yearly tax which is thereafter collected from the purchaser is 
merely a rent received by the government in view of its part 
ownership in the land. 

c. Efifective or Consumptional Income as Contrasted 
With Absolute Income 

We have already noted various deductions which must be 
made from, or additions which must be made to, one's appar- 
ent income, before we can know what the real income is. An- 
other set of deductions or additions is suggested by setting 
consum^ptional over against absolute income. When people 
speak with indignation of the excessive incomes of the very 
wealthy, they usually are directing their attention to the fact 
that people of wealth enjoy so much more than their neigh- 
bors of the good things of life, fine foods, beautiful furni- 
ture, automobiles, travel, etc. In short, they have in mind 
their consumptional income, — what they consume, in the pop- 
ular meaning of the word, for their immediate gratification. 



INCOMES: OUTSIDE FORCES 481 

Now, as a matter of fact, when incomes are conceived this 
way, there is much less difference between those of the rich 
and poor than seems on the surface to exist. The man whose 
apparent income is, say, $100,000 consumes in the ordinary 
sense perhaps only $20,000 worth of goods, the remaining 
$80,000 being invested and devoted to further production. Of 
course this new investment will increase his absolute income. 
But what if it does? He very likely does not care to alter 
materially his habits of living. He therefore has no use for 
the increase except to invest it in turn. Thus, as respects his 
total of income, with the exception of $20,000 a year, the rich 
man may be thought of as a sort of steward for society at 
large, paid a good commission indeed, but after all only a 
steward. His income, his enjoyment of goods, is not 100 times 
that of the man who earns $1,000 and spends it all on every 
day consumption, but only 20 times. As a complement to this 
point it is to be noted that, in order to realize just how great 
is the real, effective income of the poor, we must add a large 
number of gratuitous and semi-gratuitous goods which under 
modern conditions are supplied to them. Especially notable are 
the means of education and amusement furnished so liberally 
at public expense. 



CHAPTER XXXIII 

CRITIQUE OF DISTRIBUTION 

PROPOSED SUBSTITUTES FOR THE EXISTING 
PRINCIPLE 

In the opinion of not a few persons, we have now reached 
the end of our proper task; we have covered the whole field 
which can be legitimately included in a purely scientific study 
of Economics, — the analysis of the existing economic order 
in respect to structure and functions. To go further and un- 
dertake to pass judgment on the satisfactoriness of the exist- 
ing order, seems to these persons a plain transcending of our 
proper sphere. The title of the present chapter shows that 
the writer does not share that opinion. I consider it a very 
important part of the economist's task to study the present 
order in respect to its fitness or unfitness to realize the ends 
for which it must be presumed to exist. 

My principal reasons for holding this opinion are as fol- 
lows : First, in dealing with the existing economic order, as 
with any structure to which the term "organism" can be ap- 
plied, the most strictly scientific study — one which has no 
other end than a really adequate knowledge of the facts — can- 
not properly omit a consideration of the fitness of the sev- 
eral organs to perform well their respective functions. What 
physiologist, after determining the function of some bodily 
organ, would consider his task completed until he had made 
an attempt to learn the degree of efficiency attained by the 
organ in performing its function? 

But the study of the working fitness or unfitness of the 
present economic organism has another and more practical 
justification. That organism, in both structure and function, 
is to a considerable extent the product of consciously free ar- 
rangement. At many points, it is what it is because we make 



PROPOSED SUBSTITUTES 483 

it so. Doubtless, this aspect of the matter can easily be ex- 
aggerated ; the power of individuals or of society as a whole 
to alter the system in fundamentals can be, and commonly is, 
overstated. But, so long as this power exists in even a small 
degree, the student of economics is surely called upon to con- 
sider the fitness of the system, as at present constituted, to 
attain its proper ends. For where he finds it fit, he will wish 
to exert his power in support of it, and where he finds it 
unfit, he will wish to have it changed. 

It may be objected that, while we have here a problem 
which imperatively calls for solution, the task is after all one 
which does not properly fall to the economist. The solution, 
of course, requires economic data; but the problem itself is 
essentially an ethical or political one. Logical consistency, 
therefore, requires that the economist, while furnishing the 
needed data from his own science, should leave the problem 
as a whole to the men who can claim to be authorities in 
ethics or politics. There is no doubt some force in this con- 
tention ; but it does not seem decisive. First, we must al- 
ways remember that there is a degree of deference to logical 
consistency which spells pedantry rather than any practical 
good. Secondly, there are many problems in which elements 
from different fields of study are closely commingled; and a 
person who undertakes to solve these problems must weigh 
and pass upon the elements from every field. This means 
that such person must transcend in some measure the strict 
boundaries of his subject. But, if none of the persons in- 
terested can make an absolutely legitimate claim to the task, 
it would seem reasonable to turn it over to that particular 
one whose science furnishes the larger number and the more 
difficult of the data necessary to a solution. In the case be- 
fore us, this condition is surely realized by economics. 

Economics, then, would seem to be the science which 
would naturally essay the task of ascertaining how far the 
present economic order is fitted to attain the ends for which 
it must be presumed to exist. We do not mean to suggest 



484 PRINCIPLBS OP BCONOMICS 

that moralists, sociologists, et al. should be stopped from 
discussing this subject, but merely that economists can also 
discuss it, and perhaps with more propriety than any other 
group of thinkers. In further support of this contention we 
may remark that such practice is, on the whole, in accord 
with the best traditions of our science. Economists of stand- 
ing, whatever their initial professions, have rarely failed to 
comment upon the workings of our system from the teleo- 
logical standpoint and even to argue for or against proposed 
changes. And it is probable that the instructed public give 
more weight to the verdicts of economists regarding such 
matters than to those of any other class. 

In the preliminary account with which this course began, 
the existing order was represented as a coherent, rational 
whole, a system having different parts devoted to different 
functions, all co-ordinated into a great harmonious totality. 
At the same time, we saw that the organizing and regulating 
of this great totality was not conscious, but spontaneous, au- 
tomatic ; and that the particular economic process having most 
part in creating the great whole and regulating its operations; 
is exchange, and especially that element in exchange which 
we know as value, price. We explained, further, that it is 
price chiefly which determines what things shall be produced, 
how things, when produced, shall be utilized, and what pro- 
portion of the total product shall fall to the different partici- 
pants in socialized production. In the present and succeed- 
ing chapters we try to answer, not exhaustively, but with 
greater fulness than heretofore, the question : How far is this 
automatically regulated economic system a success in attain- 
ing the ends for which it exists? Does it accomplish in a 
fairly adequate manner its special task : namely, providing for 
the satisfaction of human wants in so far as this is dependent 
on economic goods? 

In view of the tone of many previous allusions to this ques- 
tion, it is hardly necessary to say that the answer here offered 



PROPOSED SUBSTITUTES 485 

is on the whole an affirmative one. Broadly speaking, we look 
on the existing economic order as measurably realizing the 
ideals which, considering the limitations of human nature, it 
is reasonable to demand from such a system. 

But in taking this position we wish to disclaim in the most 
emphatic language any intention of representing the present 
order as a perfect one, either theoretically or practically. Its 
ideals are below the highest, though necessarily so as we think ; 
and its practice is at many points far below its ideals. Many 
of its failures grow out of the limitations of human nature ; but 
not a few are needless, — can be avoided. Increased interfer- 
ence with the actual working of things, both through private 
and governmental initiative, — if for no other purpose than to 
eliminate elements which are, and always have been, incon- 
sistent with the system, — is imperatively demanded. Further, 
there can be no doubt that a degree of governmental interfer- 
ence going much beyond this, and limiting sharply the free 
working of those conditions which are most characteristic of 
the present order, ought to be, and will be, forthcoming in the 
near future. Whether in the interest of society as a whole 
or of those individuals on whom the existing system presses too 
hardly, we shall doubtless see a more extensive resort to gov- 
ernmental initiative, a greater limitation of the rights of prop- 
erty, a further restricting of the rights of inheritance and be- 
quest, a distribution of tax burdens far more favorable to the 
poor, public provision for old age pensions, and so on. 

In a word, when we defend the existing order we merely 
mean to affirm that that order is in its main outlines substan- 
tially sound, fitted to attain the reasonable ends for which such 
an order exists. Looked at broadly, it shows itself to be highly 
efficient and as much in accord with our moral ideals as we 
could expect in view of human weakness, folly, and wicked- 
ness. The general plan of exchange-co-operation, involving 
private rather than public initiative, characterized by private 
property in capital and, for most purposes, in land, with pro- 
duction, consumption, and distribution regulated in general 



486 PRINCIPLES OP ECONOMICS 

through a price resuhing from free economic action, is more 
likely than any fundamentally different scheme to work in a 
measurably satisfactory fashion. Increased regulation and a 
more liberal admixture of socialistic elements may improve 
things ; but the general system, the main framework, is sound 
and, as human affairs ^o, fairly adequate. 

In attempting to answer the general question concerning 
the satisfactoriness of the existing order, we begin with the 
■critique of that order in respect to Distribution. The reason 
for beginning at this point should readily be understood. Men's 
wants lie at the root of any economic order ; and, presumably, 
the satisfaction of men's wants is the object of such an orde-*. 
The ultimate test of an order, therefore, must be its success 
in satisfying these wants. But the phrase "men's wants" is am- 
biguous. Not all wants, surely, can be satisfied. As between 
lesser and greater wants, in the case of the individual, the sat- 
isfaction of the latter must take precedence. As between dif- 
ferent individuals, we might set up any one of many standards. 
Thus, we might rate the importance of wants according to 
their absolute magnitude, supposing it possible to ascertain this. 
That is, we might treat any want, whether that of a person con- 
tributing much to the general advantage or contributing little, 
as having an importance exactly proportioned to its intensity. 
Again, we might recognize the total wants of every person as 
having equal importance with the total wants of every other 
person. Still again, we might treat the wants of different per- 
sons as having very different degrees of importance, according 
as the part played by these persons in economic matters is of 
little or of great importance. And many other standards might 
be imagined, determining just what are the wants which we 
have in mind when we declare that the end of economic action 
is the satisfaction of "men's wants." 

But, not only is the phrase "men's wants" an ambiguous 
one, needing definition before we can proceed to pass judg- 
ment on the fitness of an economic order to accomplish its 



PROPOSED SUBSTITUTES ,487 

task — providing for the satisfaction of those wants, — the proc- 
ess by which this defining is done, the process by which so- 
ciety determines what are the "men's wants" that should be sat- 
isfied, belongs to that part of Economics which we have called 
Distribution. We could, indeed, conceive an economic order 
in which the state directly determined the importance of dif- 
ferent wants and directly provided for their satisfaction in ac- 
cord with that determination. Such a system has been tried 
more or less adequately at different times, and is usually des- 
ignated communism. It is more or less fully illustrated in the 
life of the family. But the present economic order, as also 
the much-advocated system of Socialism, solves the problem 
by authorizing a system giving to each individual a certain 
money income which he uses to buy the commodities or serv- 
ices which constitute his real income. In doing this, the 
state determines the relative importance of the total wants of 
each individual over against other individuals and leaves the 
determination of the importance of the different wants of the 
individual to be settled according to his own ratings. 

But, if the goodness of an economic order must be judged 
by its fitness to secure the fullest possible satisfaction, in their 
proper proportion, of that body of wants which society has 
decided are the ones that ought to be satisfied, and, if such 
deciding by society is effected by maintaining a particular sys- 
tem of distribution, it follows that said system is the neces- 
sary starting-point of any critique of the economic order in 
question. Once we have determined whether the system of 
distribution is or is not reasonable, the rest of our task is com- 
paratively easy. The remaining parts of the economic order 
are good or bad according as they do or do not contribute to 
the realization of the ends implicitly approved in the system 
of distribution, — according, in short, as they are or are not 
consistent with, complemental to, the system of distribution.^ 



* This argument, when combined with that of the present and fol- 
lowing chapters defending the present system of distribution, has been 
objected to on the ground that it involves circular reasoning. This ob- 
jection will be commented on in Chapter XXXV. 



488 PRINCIPLES OP ECONOMICS 

This broad statement of the matter doubtless needs various 
qualifications. Certain public or group wants are not provided 
for in the system of distribution, at least as we have treated it. 
But this qualification is manifest; and the state has no diffi- 
culty making its wants supersede all others, either by coming 
on the market with a buying power vastly exceeding that of any 
individual, or by the exercise of its absolute sovereign au- 
thority. 

Another qualification is needed because the government, 
believing that it is desirable to modify in some particular the 
working of the system of distribution and despairing of being 
able to do this by direct means, may make use of its power to 
guide the employment of social resources in order to accom- 
plish its object by indirection. Thus, as was noted quite early 
in our study, a characteristic feature of the present order, in 
its actual working, is the governmental practice of producing 
certain necessaries and supplying them to the public either 
gratuitously or at a price below what would be possible under 
private initiative. 

In spite, however, of these and other possible qualifica- 
tions, the soundness of the general proposition laid down 
above is incontestable. The system of distribution prevailing 
at any moment must be interpreted as embodying the decision 
of society in respect to the body of wants to be satisfied through 
the working of the economic order, and therefore embodying 
the decision of society as to what are the true social wants 
arranged in the order of their importance. If following the 
guidance derived from this system of distribution results in 
what seems, on other grounds, to be a wrong use of our re- 
sources, this must be viewed as an indictment, not of the 
process whereby production is regulated, but rather of the sys' 
tem of distribution which society has authorized. If amend- 
ment is needed, that amendment should, with few exceptions, 
be directed to the alteration of the source of the trouble, the 
system of distribution itself. Accordingly, our critique of the 



PROPOSED SUBSTITUTES 489 

present economic order begins with a consideration of the rea- 
sonableness of the system of distribution embodied in that 
order. 

The general principle underlying the present system of dis- 
tribution, we will remember, runs as follows : 

When competition is free, each individual tends to get 
approximately that income which expresses the marginal sig- 
nificance of the natural supply of the type of contribution 
made by himself or his property to the sum of utilities, and 
which at the same time expresses approximately the m.ar- 
ginal disutility involved in making that contribution. Is this 
principle, on the whole, wise and just? 

No adequate critique of the dominant principle of dis- 
tribution can be effected without contrasting that principle 
with possible substitutes. It will perhaps be best, therefore, 
to begin by examining some of the more plausible substi- 
tutes that have been suggested, reviewing their merits and, 
if such exist, their logical or practical defects. 

One principle of distribution often highly commended is 
that which we try to realize in family life, as also in the life 
of the state during periods of greatest social exaltation. I 
mean the principle that each shall receive of the common in- 
come in proportion to his need, — having given in proportion 
to his capacity. This seems to have been, and to be still the 
formula of the highest type of communism. "Prom each ac- 
cording to his capacity; to each according to his need." 

To the present writer there seems no room for argument 
as to the ethical superiority of this distributive ideal over all 
others. If human nature were capable of maintaining it, no 
other formula would deserve a moment's consideration. But 
unfortunately there is reason, and perhaps quite conclusive 
reason, to doubt the sufficiency of human nature in this re- 
gard. Even those few hundreds of people who succeed in 
living somewhat near such an ideal in Amana and other com- 
munistic associations admit that their very limited success is 



490 PRINCIPLES OF ECONOMICS 

made possible only because of certain intense religious senti- 
ments which are common to all the members. And no one 
seriously believes that uniform sentiments of this kind exist, 
or can ever possibly exist, in more than a small minority of 
the hundred millions of men, women, and children who con- 
stitute the population of the United States. 

Another ideal which seems to have been more or less con- 
sciously held by many socialists of the earlier type, is that 
each person should share in the joint income in proportion to 
his labor. This of course can be differently interpreted. One 
may have in mind the sacrifice made or the results accom- 
plished. And he may conceive the sacrifice as measured in a 
subjective standard or as measured in an objective one, like 
time. 

In general, the socialists seem to have had in mind primar- 
ily the sacrifice of labor as measured by the time spent in ap- 
plying it. Yet they tried to avoid divorcing this completely 
from results, by insisting that the labor must be labor which 
produced things, and standardised labor, at that, — labor which 
in the given place and time was "socially necessary" to ac- 
complish the result. Marx* further conceded that we could 
not treat all kinds of labor as exactly the same, though he 
would not admit qualitative differences. The labor of the 
artist and that of the mechanic must be treated as differing in 
intensity, or density, so to speak. That is, one hour of the; 
artist's labor should be reckoned as the equivalent of, say, 
three of the mechanic's. 

The labor ideal as thus interpreted, though not without 
points of merit, has fundamental defects which render it un- 
worthy of extended discussion. Any scheme of distribution 
which can reasonably ask for society's favor must in serious 
measure make economic reward conditioned upon economic 
significance, mriist make differences of economic reward cor- 



* The most eminent of the theorists who laid the foundations of 
Socialism. 



PROPOSED SUBSTITUTES 491 

relative to differences in economic significance. This Marx 
tacitly admits by refusing to reward labor which produces 
nothing useful, and by insisting that all labor must be stand- 
ardized, reduced to "socially necessary labor." But differences 
in the economic significance of the several kinds of labor 
often show no correspondence either to labor time or to labor 
intensity. It is therefore quite out of the question that labor 
as measured in labor time, even when corrected for intensity, 
should be accepted as the principle of distribution. 
, Another conceivable ideal of distribution, more or less 
definitely held by many intelligent people, may be called the 
Social Service ideal. This idea differs from the one embodied 
in the present order in that, under the latter, each person re- 
ceives a price which expresses the significance of his services 
to individuals graded according to the buying power they 
possess; while, under the social-service principle, a man would 
be paid according to the significance of his services to the 
group as a whole or to all individuals without any reference 
to their wealth or poverty. 

This ideal has at the first hearing an extremely plausible 
sound. There is something particularly obnoxious in the 
fact that, under the present system, the power to furnish serv- 
ices of a very trivial sort, or even services highly immoral in 
their character, enables the owner to command a large in- 
come, because persons desiring such services chance to pos- 
sess great buying power. It would seem much more equita- 
ble that one's income should depend upon the services of real 
worth which he renders direct to the humanity which is in all 
men alike, or to the worthiest needs and demands of the en- 
tire social group. 

But further examination shows this principle to be seri- 
ously deficient. First, in so far as it concerns the group as a 
whole, the new principle is already contained in the one which 
governs our present system. The group is fully organized 
and," through the use of the sovereign power of taxation, can 
insure that group wants are satisfied at whatever cost, — can 



492 PRINCIPLES OF BCONOMICS 

see in other words, that men are paid in accord with the im- 
portance of the service they render to the group. 

Secondly, the proposed ideal, as applied to individuals, is 
self-contradictory. For a principle of distribution simply 
can not pay according to the importance of the service ren- 
dered without paying according to the importance of the serv- 
ice to individuals graded according to buying power, (a) 
Since men are to be paid in accord with services rendered, 
they are to be paid unequally, (b) This means that the ef- 
fective demand for commodities and services will be unequally 
distributed, (c) But the distribution of effective demand will 
necessarily determine in what proportions people will actually 
consume goods, (d) But the only importance which can sig- 
nify anything is importance to actual consumers, (e) It fol- 
lows, therefore, that to pay for services according to their 
importance to individuals without discrimination as to wealth 
or poverty, is to pay for those services in accord with their 
importance to persons who do not get them at all, — a process 
which really amounts to paying for services without regard 
to their importance. 

The last ideal of distribution which we shall here dis- 
cuss is that of equality. To each an equal share ; but from 
all, service, is its motto. This is the more usual communistic 
ideal, and it is apparently favored by many socialists. Nor 
can we wonder at its popularity, for there is indeed much 
to be said in its support. The greatest discomfort from pov- 
erty — ^not the absolute want of the poor, but their contrast 
with more favored neighbors, — would, under such a principle, 
be overcome. Further, equality would not fail to bring a de- 
gree of satisfaction to many people, those who descended as 
well as those who rose, even if the equality were one but little 
removed from misery. 

But, after all, this principle is quite impractical. Equality 
in income, though serving well various sentimental considera- 
tions, would sacrifice to these the real, material welfare of all 
classes. Further, it would not even embody the ethical 



PROPOSED SUBSTITUTES 493 

ideals which dominate practically the whole community. For, 
however people may feel toward interest, rent, and profits, 
they almost universally believe that wages and salaries ought 
to bear some relation to service rendered. 

But the subject is too important to be so lightly disposed 
of. Are we right in saying that an attempt to enforce com- 
plete equality would sacrifice the real material welfare of all 
classes to mere sentimental considerations? In support of 
this view, there are three chief sets of facts : 

I. In the first place, giving some persons larger in- 
comes than the rest of us may be directly required in the 
interests of the rest of us, in that the larger incomes are nec- 
essary to enable those persons to perform efficiently the im- 
portant tasks we have assigned them. Thus no thoughtful 
person would contend that the people of the United States 
could afliord to have their chief executive live on $1,000 a 
year, even if he were perfectly willing to do so. To perform 
at all well his services to the people of the nation, he must 
spend, on matters more or less personal in their nature, many 
times $1,000. What is true of the president of a great re- 
public is true in only lesser degree of "hundreds of other men. 
In fact, if we sufficiently narrow the circle of interested per- 
sons, it is true in a way for almost every male citizen. To the 
other members of his family, it is more important that the 
breadwinner, though the humblest of day-laborers, should be 
well fed than that the rest should be, because only so can he 
be fit to earn the income on which they all depend. But, of 
course, the point is more forcefully illustrated in the greater 
relations of society. To those men whose functions involve 
large responsibilities, intense mental activity, and great nerve 
strain, we must, for our own sakes, give large incomes, in 
order that they may prove resolute, clear-sighted, well-poised, 
and in other respects fitted for their great tasks. 

The objector may say that we really have here a case not 
of better income, but rather of collateral expenses. Needs of 
this kind should be provided for as part of the outlay of the 



494 PRINCIPLES OF ECONOMICS 

office which the man holds. If $i,ooo is the best income the 
community can afford its members, the president, as a man, 
must be satisfied with that income ; though on his office we 
may spend $100,000. Doubtless something, perhaps much, 
could be done along this line; the writer heartily believes in 
employing such a policy wherever possible. But the whole 
difficulty could not be met in this way. A need is often so 
personal, so individual, in character that it cannot be provid- 
ed for save through a fund placed at the disposal of the per- 
son interested. One person requires one sort of relaxation, 
perhaps a very inexpensive one; another requires a very dif- 
ferent sort, perhaps a very costly one. Further, the employ- 
ing public (under socialism), whose opinion is greatly influ- 
enced by persons not in a position to judge of the personal 
needs attaching to the higher social functions, would com- 
monly underrate those needs, as is shown in the niggardly 
salaries now paid public officials in democracies. In conse- 
quence, provision for this kind of need, if made in a formal 
sort of way, would probably be far too small. 

2. The preceding paragraph has named one reason why 
inequality of incomes is necessary in the interest of the very 
persons whose apparent incomes would be raised by the abo- 
lition of that inequality. A second and still better reason, 
belonging in a way to the same class, is found in the fact that 
unless incomes are unequal, they will not even approximately 
express the relative sacrifices which men undergo in contrib- 
uting different services, and, so will induce an oversupply of 
services which involve small sacrifices and an undersupply of 
the opposite kinds. 

This difficulty has always been recognized by the crea- 
tors of Utopias ; and to meet it a great variety of ingenious 
schemes have been devised. Thus, some writers have pro- 
posed that conscripts from all classes should have to serve a 
certain length of time in objectionable trades. Others have 
reserved these occupations for the convicts. More recently, 
we have had much stress laid on (a) variations in the length 



PROPOSED SUBSTITUTES 495 

of the labor day and (b) honor rewards. An undesirable 
occupation might be made less unattractive by reducing the 
day from 6 hours to 4, or 3. So, attractiveness might be 
given the occupation by attaching thereto decorations and 
official rank. 

Now, it seems highly improbable that these devices should 
have anything like the effectiveness which is anticipated from 
them. The honor device, especially, overlooks the fact that 
honors, to be effective as a stimulus to emulation, must not be 
too commonly employed. Gaining a prize is not worth while, 
if almost all the contestants gain prizes. Being a member of 
an academy which every one can join by paying $5, will at- 
tract people only so long as they are ignorant of the facts. 
But, whether these schemes are practicable or not, there can 
be no doubt that they are inconsistent with real equality. Why 
do I object to my neighbor's having a better income than I, 
supposing mine to be enough for a decent life? Mainly, it is 
because the spectacle of his enjoying advantages which I can- 
not enjoy detracts from my peace of mind. Now, what mat- 
ter as to the source of these advantages? To see him watch- 
ing the great national game, or comfortably lying in the shade, 
while I toil and sweat in the sun would surely awake in me 
an unpleasant sense of contrast if these privileges were grant- 
ed him as a direct reward for accepting some task, just as 
truly as they now do, when they come as an indirect reward 
for that same service. So, again, one of the greatest objec- 
tions to the inequality of the present order is that it gives to 
the men of larger incomes a higher place in the estimation of 
their fellows, better social standing. Will this deeper sort of 
inequality be any less obnoxious when it is directly created 
than when, as at present, it is the indirect result of inequality 
in money income? 

3. There is still a third reason — and this is the weightiest 
of all — why people generally, considered as consumers, must in 
their own interest prefer that some other persons should re- 
ceive better incomes than themselves. There must be inequality 



496 PRINCIPLES OP ECONOMICS 

of incomes, some contributions must command much higher 
prices than other contributions, because only in this way can 
it he made certain that society will make the best use of its 
resources, its productive capacities. 

In an earher discussion it was shown that, in a world 
Hke ours where different kinds of primary factors, hmited in 
amount and capacity, enter in different proportions into the 
production of different commodities, each of those kinds of 
factors will have its ozvn special significance or importance 
as determined by its contribution to the production of goods. 
Further, under the present system of free private initiative 
and exchange, the assigning to each factor a price which ex- 
presses approximately its true significance is accomplished 
automatically. Now, by some process or other, the same task 
must be performed under any system of economic organi- 
zation — communism, sociaHsm, or what not. For, otherwise, 
we could have no assurance that we were' making the best 
use of our capacities. 

In the first place, assigning to things their proper price 
would be necessary under socialism no less than under the 
present order, as a part of the public system of bookkeeping, 
If the state were to become the sole landlord, capitalist, and 
entrepreneur, it would be obliged to carry on an elaborate and 
complete system of bookkeeping in order to have at hand the 
knowledge of conditions necessary to a reasonable conduct of 
economic affairs; and, in this bookkeeping, the state would 
need to credit each primary factor with the true significance of 
that factor, since, otherwise, it would frequently waste im- 
portant factors on unimportant commodities. In short, 
whether or not men were actually to receive unequal incomes, 
they would have to be credited with unequal contributions. 

But when each person has been credited with the true 
value of his contribution, can it be doubted that, under any 
system which is in the remotest degree practicable, that value, 
or something approximating it, would have to be paid to the 
man who made the contribution? We say "under any system 



PROPOSED SUBSTITUTES 497 

which is in the remotest degree practicable"; for one might 
admit that a despotically organized communism, effecting and 
regulating co-operation through authority, could "exploit the 
workers" — to use a socialist phrase — could give equal remu- 
neration for very unequal services. But surely no communis- 
tic plan yet proposed is to be taken seriously. We need, there- 
fore, to consider only socialism. Could that system of eco- 
nomic organization escape paying men in proportion to their 
contribution ? 

The answer is surely a negative one. One could, indeed, 
conceive a socialist state which at first thought would seem 
able to avoid the necessity of adjusting reward to contribu- 
tion ; I mean a state conterminous with the earth and organ- 
ized as a completely centralized despotism. Such a state might 
seem to be emancipated from all necessity for paying its work- 
ers according to any standard other than its own will, because 
competition would have been completely eliminated. As a 
matter of fact, however, I doubt if even this vast despotism 
would be able to exploit the capable in the way supposed, and 
that for two reasons : ( i ) the capable would probably be in 
power, and (2) whether or not, they would know their own 
importance and, by a refusal to work for less, would compel 
the authorities to raise their pay till it approximated the real 
value of their services. But it surely is mere idleness to build 
upon the fantastic assumption of a co-operative common- 
wealth coextensive with the earth and organized as a com- 
pletely centralized despotism. If we ever have a collectivist 
state, it will be one among many sovereign states, and one in 
which local autonomy, municipal and provincial, still exists. It 
will, therefore, be a state in which competition still exists. 
Different municipalities, different commonwealths, different 
sovereign states will more or less vie with each other in try- 
ing to attain the highest efficiency, and so will drive one an- 
other into paying the persons who supply the different kinds 
of productive services something like what those services are 



498 PRINCIPLES OF ECONOMICS 

worth. But, in doing this, they will of course make the shares 
of these persons in the social income unequal. 

In short, while inequalities in distribution need not always 
be so great as they are today, while they would be much re- 
duced under a socialist regime and no doubt will be much re- 
duced under the present regime ; still, inequality of some de- 
gree is inevitable. The ideal which would give to each citi- 
zen an equal share with every other is quite out of the ques- 
tion. The remuneration received by each must bear some 
relation to his contribution. 

Finally, as a general result of the discussion in this entire 
chapter, what do we have? We have examined all the chief 
substitutes for the existing principle of distribution that have 
been proposed ; and while we have found them commendable 
in many respects, and especially as regards their humanitarian 
purpose or intent, we have also found them one and all, on 
the whole, impracticable, — it is doubtful whether, for the pres- 
ent at least they can be established. This being true, it is vir- 
tually certain that the existing principle, with possible modi- 
fications, will for some time be continued. It therefore be- 
comes of the first importance to determine whether that prin- 
ciple, since it needs must be endured, is any more defensible 
than these others. To that task we shall turn in the following 
chapter. 



CHAPTER XXXIV 

DEFENSE OF THE PRESENT SYSTEM OF 
DISTRIBUTION 

In the chapter just concluded, we tried to prepare the 
way for a defense of the existing system of distribution, es- 
pecially in respect to its general principle or ideal, by show- 
ing the impracticability of the ideals which have been pro- 
posed as substitutes for the one dominating the present order. 
We now undertake the positive defense of the present sys- 
tem, both in respect to its general principle or ideal and in 
respect to the more prominent features which appear in the 
working out of that principle. We begin with the former of 
these tasks. 

Section A. Defense of the Service- Value Principle 

That the service-value principle is entirely defensible, if it 
is not in fact the only defensible one, has almost necessarily 
been established in arguing for the impossibility of the equal- 
ity ideal. But it is perhaps best to give this point a formal 
statement and comment on two or three objections. 

There is one justification for the Service- Value principle 
which, from its very nature, can hardly fail to be decisive. 
That one is necessity. Under no other principle could the 
economic action of a society, in which any degree of indi- 
vidual liberty or local self-government was retained, be so 
guided as to make the best use of its capacities. Theoretical- 
ly, perhaps, a despotic state, world-wide in extent and com- 
pletely centralized in administration, could, after much ex- 
periment, approximate the result by ruthlessly exploiting the 
capable in the interest of their fellows and of society in gen- 
eral. Even here, however, it would be necessary to credit 



500 PRINCIPLBS OF ECONOMICS 

each agent in production with the whole value of his contri- 
bution. For value, price, is nothing more than a special method 
of expressing the relative importance of things. Correct 
prices, therefore, are necessary to furnish us with correct es- 
timates of this relative importance. But, further, in deaHng 
with elements the output of which depends on human con- 
sent, it is not enough that we have correct paper prices, — 
bookkeeping prices, — we must also have correct real, objec- 
tive, prices. We must pay correct prices ; for, only in that 
way, can we insure the forthcoming of the several elements 
in their proper proportion. 

Even a socialist state, if such a one is ever established, 
will find itself obliged to pay its employees in a general accord 
with the true values of their contributions. It may effect 
vast improvements for the majority of men by eliminating 
many violations of the service-value principle which corrupt 
the present order. But, after all, it will be compelled to adopt 
as its general guiding principle the same old rule that the val- 
ues imputed to things must be a true expression of their mar- 
ginal significance, and that things bought on the open mar- 
ket and having prices, must have prices which correctly ex- 
press their true value. 

The foregoing paragraphs have outlined the chief positive 
argument in favor of the Service- Value principle. Let us take 
a moment to comment on one or two objections. 

I. There appears among many people a disposition to 
criticise the ruling principle of distribution because it pays 
men in accord with their effective utility rather than their ab- 
solute utility. Thus, the utility of coal miners as a class is 
surely far greater than that of high-grade singers as a class ; 
but society pays a miner for an hour's work, perhaps, 40 cents, 
while it pays the singer for an hour's work, perhaps, $2,000. 
This objection always arouses a sympathetic response in the 
popular mind ; but to the student who has acquired a fuller 
comprehension of economic relations, it is quite without point. 
A person who puts forward this objection really admits by 



DISTRIBUTION SYSTEM DEFBNDBD 501 

implication that it is right to have men paid in accord with the 
importance of their services; he only complains that we set 
the wrong standard for judging importance. But his com- 
plaint is of course a mistaken one. The real importance of 
any man is his effective importance, — what zve should lose if 
we lost him, not what we should lose if we lost his whole 
class. For usually the alternative facing us is, not keeping 
or losing the whole class, but keeping or losing an individual 
of the class. And what we lose by losing any individual of 
a class is only the utility of the least useful of the class, since 
the loss of any higher utility would be avoided by transfer- 
ring the least important member of the class from his present 
task to the higher one. 

2. Another familiar objection to the Service- Value prin- 
ciple is that it pays a man, not in accord with his ozvn specific 
utility, but in accord with the utility of the marginal member 
of his class. Thus, a man may be performing some service 
for which his employer is glad to pay him, and does pay 
him, $2 a day ; when, without any fault on his part, an in- 
creased supply of labor comes on the market and lowers the 
marginal utility of his class to $1.50 per day, with the final 
result that, though still performing the $2 service, he now 
gets only $1.50. Viewed from this man's standpoint the sit- 
uation naturally makes a powerful appeal to one's sympa- 
thies. But what about the incoming man? He surely cannot 
be paid more than the $1.50 which he really earns. But, if 
the first man continues to get $2, while this second one who 
is working just as hard and is perfectly able to replace the 
former gets only $1.50, our sense of justice would be outraged 
just as much as in the former case. 

But, again, the objection is quite untenable logically. If a 
man is to be paid in accord with his importance at all, the im- 
portance in question must be real, effective importance. But 
the real, effective importance of a man is determined, not by 
the importance of the thing he accomplishes, but by the im- 



502 PRINCIPLBS OP ECONOMICS 

portance of the thing which the marginal member of his 
class accomphshes. 

3. Probably the misgiving which most persistently re- 
curs to all of us concerning the service-value principle, is that 
to defend or even patiently accept it, one must be somehow 
too cold-blooded, too insensible to considerations of sympa- 
thy, humanity, love of one's fellows. When one is exercising 
his logical faculties on mere abstractions or is dealing with 
mere things, he can recognize the working of an inflexible sci- 
entific principle, without a qualm. But here the interests at 
stake are the incomes and, therefore, the happiness of living 
human beings. Is there not something inherently shocking 
to our moral sense, even to our sense of mere decency, in the 
advocacy or adoption of a principle which places interests 
like these at the mercy of so unmoral a thing as the law of 
supply and demand, or the law of marginal utihty ? Does not 
every right-minded man respond with full approval to the 
belief expressed by Mill that a time would come when the 
division of society's product, instead of being a matter of au- 
tomatic, mechanical, regulation, "would be made by concert 
on an acknowledged principle of justice f" In fact, is not 
this whole attitude of mind which conceives human beings 
as mere instruments, mere things, inherently wrong? Must 
we not rather at all times conceive human beings as ends in 
themselves ? 

Now there is surely some force in all this. We saw in the 
preceding chapter that it is at least possible to imagine a prin- 
ciple different from, and higher than, the one now operative. 
We believe also that the working of the principle in the actual 
order can be greatly improved by changes which would bet- 
ter satisfy the demands of moral and humanitarian senti- 
ment above alluded to. And we believe that its worst ten- 
dencies could be, and are, not a little offset by a secondary 
distribution through voluntary benevolence and the use of the 
taxing power, — all this in obedience to the same moral and 



DISTRIBUTION SYSTEM DEPBNDED 503 

humanitarian sentiment. But, when all is said and done, we 
can only imagine a radically different system — not really es- 
tablish it. We can only modify the working of the present 
principle, not overthrow it ; we have no choice but to submit to 
the principle as it is. Whether the principle shocks our senti- 
ments or not, therefore, the least we can do as scientific stu- 
dents is frankly to recognize its reality. 

But in fact there is no good reason why the existing princi- 
ple of distribution should offend our moral sentiments. Rath- 
er, the contrary. If the service-value principle is the only one 
which can sustain society from falling into the poverty and 
misery of communism, then it would not be difffcult to make 
out a case showing the principle to be positively humanita- 
rian. Nor need we, in the second place, feel too keen a re- 
sponse to the notion that it is wrong ever to conceive of hu- 
man beings as functioning in some relations like mere instru- 
ments or things. 

There is nothing per se unworthy or degrading in taking 
one's turn at being a mere thing in economic society. Doubt- 
less we all ought to have our opportunity to live for living's 
sake, to be ends rather than means. But this is perfectly con- 
sistent with our being mere means to an end much of the time. 
Further, it is quite easy to overstate the case. Men who empha- 
size their right to be ends are likely to overreach themselves. 
Most men of mature years have learned that, in the long run, 
scarcely anything is really worth while, even from the purely 
selfish standpoint, except to set oneself a suitable task and 
conscientiously perform it.* 



* By a curious inconsistency, people who emphasize this objection 
seem to have no sensitiveness on the matter, provided the station in 
which one serves as a mere means is sufficiently dignified. We hear 
nothing in this vein when they are speaking of doctors, lawyers, pro- 
fessors, politicians, and others of the higher classes of workers, though 
of course these persons are, on the professional side, mere instru- 
ments, mere things, just as truly as the common laborer. 



504 PRINCIPLES OP ECONOMICS 

Section B. Defense o£ the Three Property Incomes in the 

Abstract 

In the preceding section we have defended the general 
principle or ideal of distribution embodied in the present sys- 
tem, as necessary to social welfare, and, on the whole, reason- 
able and just. But this leaves much of our task unaccom- 
plished. The service-value principle might be all right, ab- 
stractly considered; but it can be realized only under a con- 
crete set of conditions. It must work itself out through defi- 
nite institutions, legal prescriptions, customs, economic laws, 
and so on. As thus working itself out, is it defensible? The 
conditions in question, as we know, are very numerous and 
complex. To cover the whole matter thoroughly is of course 
quite beyond us. We must content ourselves with comments 
on the most important points. 

Primary economic distribution, as we have seen, depends 
chiefly on the kinds of shares or sources of income which are 
permitted and the natural laws determining the volume of 
these shares. The former of these two conditions depends 
largely on what kinds of property are permitted : especially 
whether private persons may or may not own capital or land. 
The latter is the general principle of distribution we have al- 
ready considered. Less immediate conditions are those which 
determine secondary distribution, for example, the natural laws 
regulating the prices of those goods in the purchase of which 
we spend our money incomes, and the distribution of public 
burdens such as taxes. We shall consider mainly the legiti- 
macy of the shares or sources of income by which primary 
distribution is determined, more especially the three property 
incomes, since the labor income, wages, is not, in general, se- 
riously challenged. In the present section, we consider the 
legitimacy of these different shares in ahstracto, that is, as 
naturally going to some one who can establish a valid title 
to the property from which they spring. Since the validity of 
a title set up by the state would probably not be challenged 



DISTRIBUTION SYSTEM DEPENDED 505 

by any one opposed to the present system, we will argue for 
the legitimacy of the shares in question, supposing the state 
to he the recipient of those shares. 

I. The Legitimacy of Interest in the Abstract 

In an earlier connection, we discussed the various mani- 
festations of the interest phenomenon in the existing order, 
naming two general classes : explicit and implicit interest. 
Under thorough-going socialism, explicit interest — interest on 
contractual loans — could exist, if at all, only on the smallest 
scale ; since, with the state occupying the position of sole en- 
trepreneur as well as that of sole capitalist, productive bor- 
rowing from the state would be consciously restricted within 
very narrow limits. Accordingly, interest in such a state 
would mostly be of the implicit type, — it would show in the 
prices of goods. In the case of goods which were sold to 
private persons it would show in the prices quoted on the 
market, and in all cases it would show in the prices recorded 
on the books of the government. We will begin with the 
second kind of prices, those recorded on the government's 
books. 

As has already been pointed out, if government hopes to 
perform with any sort of success the stupendous task of con- 
ducting all industrial activity, it must keep a complete, de- 
tailed, and trustworthy set of accounts to represent the true 
values of both immediate and ultimate goods. Without these 
accounts the government could never be sure that it was con- 
ducting its vast interests in such a way as to make the best 
use of the resources at its command. In short, the govern- 
ment of a socialist state will need just as elaborate and com- 
plete a system of values and prices as that existing today. 

But it is of course possible that these necessary values will 
in many instances be somewhat different from those of an 
individualist regime ; it is even possible that some particular 
values may disappear altogether. A commodity or a service 



5o6 PRINCIPLBS OF BCONOMICS 

comes to have value only when two conditions at least are ful- 
filled: (i) its disposal must yield some advantage, and (2) 
there must be some limitation on its supply whether absolute 
or conditional (cost). Now it is conceivable that, under so- 
cialism, one or the other of these conditions will be lacking in 
certain cases zvhere, under the existing regime, both are pres- 
ent. Thus, the advantage derived from a service today, may 
be of such a nature that it will disappear when socialism is 
established — for example, the services of an office furnishing 
abstracts of titles. On the other hand, the effective limitation 
of supply now existing may be due to the arbitrary action of 
a monopolist, and so will be bound to disappear under social- 
ism. 

Are either of these changes possible in the case of inter- 
est? Would the advantages for which interest is paid disap- 
pear under socialism? Would the supply of the condition 
which furnishes that advantage prove so abundant that it 
would no longer have marginal utility and therefore no longer 
have value? A negative answer to both questions seems in- 
evitable. 

First, the advantages for which interest is paid would not 
disappear under socialism. The essential nature of the trans- 
action through which interest arises is the exchanging of fu- 
ture for present goods. That is, interest is usually a price 
paid for the privilege of having goods now, though we do not 
pay for them till later. Now, this privilege carries with it 
different advantages under different circumstances. Of these, 
the greatest is described by saying that capital is productive. 
By getting control of a fund of wealth nozv while freed from 
the necessity of paying for it till later, we are enabled to choose 
the more efficient methods of production which require longer 
periods of time. A lesser advantage flowing from the privi- 
lege of exchanging future for present goods is that it enables us 
to substitute payment at a more favorable, for payment at a 
less favorable, time. Thus, a man starting on a new job has 
perhaps no surplus in his purse ; a month later he will have 



DISTRIBUTION SYSTEM DEFENDED 507 

seventy-five dollars ; an exchange which enables him to bring 
into the present the better provision of the future will surely 
give him an advantage. 

Now, would these advantages continue to exist under so- 
cialism? Surely, yes. It might be that the second would 
cease to be effectual because the socialist state would refuse to 
make advances to imprudent or unfortunate citizens who 
wished to anticipate the provision of the future ; but the need 
would certainly exist and so the possible benefit. As respects 
the supreme advantage derived from the possession of capi- 
tal, — being able to choose more efficient methods of produc- 
tion — this certainly could not disappear save on the hypothe- 
sis that the whole order of physical relations was overturned 
and a new one established in which direct, immediate meth- 
ods of labor were more efficient than those which utilize na- 
ture's powers. Of course no one anticipates any such revo- 
lution in the order of the physical universe, as a result of the 
establishment of socialism. Under that system, it would still 
be desirable, and even necessary to make tools before we made 
tables. Hence the power to wait would be just as necessary 
as under the present order. The privilege of exchanging fu- 
ture against present wealth v/ould be of advantage to the gov- 
ernmental entrepreneur of the socialist system just as it is 
to the individualist enterpreneur of our system. 

But, in the second place, is it at all likely that the other 
condition which is essential to give waiting power a value, 
namely, the scarcity of the supply, will disappear under so- 
cialism? In support of an affirmative answer, some one might 
say that the scarcity existing at present is artificial, and so 
would be sure to disappear when the only capitalist is the 
state. But this is manifestly unsound. There is scarcely any 
other part of the economic structure in which competition is 
so free as in the market for capital. An artificially controlled 
supply is quite out of the question. If the scarcity now exist- 
ing is to disappear under socialism, this will have to be for 
some other reason. Can it be that capital will increase far 



5o8 PRINCIPLES OP BCONOMICS 

more rapidly under socialism than it does at present? Surely 
the contrary is to be anticipated. The absence of excessively 
large incomes will cut off one great source of capital; an- 
other will go with the removal of the necessity for saving 
on the part of the masses under a regime which assures 
every one a livelihood; finally, the direct turning back of in- 
come into business, on which socialism must almost entirely 
rely, will be much more difficult when all authority is in the 
hands of a democracy, eager for the present and reckless 
of the future. 

It hardly seems necessary to carry this discussion further. 
We cannot doubt that under socialism the right to dispose of 
present goods, while paying for them in the future, the right 
to use waiting power, would have a marginal utility and 
would, therefore, have value. So, in every relation where 
implicit interest appears under the present regime, it would 
be certain to appear in the socialist bookkeeping. 

But we have still to answer the question whether implicit 
interest would be present in the prices of goods sold on the 
market. For example, would the state find itself practically 
obliged to charge more for goods the production of which in- 
volved the use of large quantities of fixed capital than for 
goods which were almost entirely produced by current labor? 
Doubtless another policy could be conceived. While keep- 
ing its books soundly, the state might decide to sell some 
goods below cost — cost being interpreted to include interest 
on capital. But it could not pursue such a policy without un- 
equal and unjust treatment of its citizens. For citizens would 
.usually differ greatly in respect to the amounts they would 
consume of these goods which embody a large interest ele- 
ment. On the other hand, the burden of accumulating cap- 
ital, which will enable society to secure the production of 
such goods, would fall on people generally. The only way to 
insure fair play, then, would be to raise the prices of those 
goods till they were high enough to put the burden of produc- 
ing the goods entirely on those persons who consumed them 



DISTRIBUTION SYSTEM DEFENDED 509 

Accordingly, we conclude that interest in itself is a legitimate 
element in price, — that, supposing interest to be absorbed by 
the state as the sole capitalist, it is an entirely legitimate share 
in distribution. 

2. The Legitimacy of Profits in the Abstract 

Of all the regular economic incomes, profits would proba- 
bly show greatest modification under a socialist regime. Yet 
even profits would doubtless appear in somewhat disguised 
form, and, hence, must be reckoned as a perfectly natural and 
legitimate source of income under the proper conditions. In 
support of this contention, little more need be said than to re- 
mind the reader of the points previously made with reference 
to this source of income. Profits, as popularly interpreted, 
include three elements : wages, interest, and profits proper. 
The wages element would of course persist under socialism. 
So also would the interest constituent, as we have just seen. 
What, then, as to pure profits, — the excess over ordinary in- 
terest received by the entrepreneur who turns over managerial 
functions to others? 

That excess, we have argued, owes its origin to the bur- 
dens of taking the final responsibility in production. Of these 
burdens, the chief is the fear of loss, though, under the exist- 
ing order, other psychological elements are doubtless present. 
Now, it seems quite certain that, in a socialist regime, this 
burden would be altered fundamentally in character, as also 
somewhat diminished in amount ; but it would not be elim- 
inated. At present the burden takes the form of a risk of 
never-to-be-compensated loss ; and profits constitute the prize 
necessary to induce men to overcome their natural indisposi- 
tion to assume the risk. But, under a system which concen- 
trated all resources in the hands of a single owner, all risks 
would be pooled, and, therefore, would almost disappear as 
risks, being replaced by the certainty of fairly regular losses. 

In other words, the socialist state would be obliged every 



5IO PRINCIPLES OP ECONOMICS 

year to write off a considerable volume of losses. That is, 
some of its expenditure would have gone for naught. To 
make its books balance, this excess of expenditure would 
have to be charged against all, or some portion, of the products 
which resulted wherever industry was successful. Naturally 
the products chosen would be those of the industries where 
the losses had occurred. In no other way could we avoid bur- 
dening other citizens in the exclusive interest of those who 
consumed the products of riskful industries. We conclude, 
therefore, that profits constitute a legitimate, even neces- 
sary, element in an economic system, — being inevitable even 
in a socialist state. 

3. The Legitimacy of Rent in the Abstract 

Here an extended discussion is even less called for than 
under Profits. Rent inevitably emerges as the result of any 
process of natural value determination. It could not help 
existing under socialism. As soon as the best land, cultivat- 
ed to the point of diminishing returns, proves unable to supply 
as much product as is demanded at some price above cost of 
production, price rises and in so doing creates a surplus over 
cost which under any regime is bound to be credited to the 
given piece of land. Being so credited, the land takes on 
value as the source of that surplus. If the surplus is large, 
the value is large. All this is inevitable under any rational 
system. The socialist state probably could not get rid of it 
by any action however arbitrary. This would apply, not mere- 
ly to the bookkeeping of the state, but also to the system of 
market prices. For surely the socialist state could not have 
different prices for the same product in the same time and 
place, and it could not fix as the one price anything under the 
marginal cost of production ; since, in so doing, it would dis- 
criminate in favor of the consumers of the particular com- 
modity in question as against the rest of its citizens. But, 
if the state leaves prices to be fixed at marginal cost, it thereby 
permits rent to exist. 



DISTRIBUTION SYSTEM DBFENDBD 511 

To conclude, then, interest, profits, and rent may un- 
doubtedly be considered legitimate, supposing the state to be 
the sole capitalist, entrepreneur, and landlord. These shares 
correspond each to some portion of the output, which portion, 
on any rational system of valuation, is to be imputed to the 
productive factor involved. They would, therefore, exist, 
and ought to exist, if the present economic system were re- 
placed by the co-operative commonwealth — only they would 
•fall to the state and so would benefit all rather than the few. 

Section C. The Legitimacy of Interest, Profits, and Rent 
as Sources of Private Income 

Having ascertained that interest, profits and rent would 
be legitimate shares under a socialist regime, we come now 
to the last and most difficult part of our task. The real world 
as we know it is not governed on the socialistic plan, nor is it 
likely soon to be. Property is not owned and controlled by the 
state but by private individuals. Private individuals, there- 
fore, assume the roles of capitalist, landlord and entrepre- 
neur, connected with the ownership of property, and in these 
roles they receive the incomes originating in property, inter- 
est, rent and profits. Are the shares legitimate under these 
conditions? Is it right for individuals to receive them? 

I. The Legitimacy of Private Interest 

Those who affirm that there is something essentially wrong 
in permitting private persons to receive interest must main- 
tain either (i) that it is essentially wrong to permit private 
persons to own capital, or (2) that, though right to permit 
private persons to own capital, it is essentially wrong to permit 
them to receive a net income from that capital. 

The first of these alternatives surely need not delay us 
long. As against communism, a defense of the right even to 
own capital without deriving any income therefrom would 
be necessary; for communism holds that no ownership of 



512 PRINCIPLES OP ECONOMICS 

property is legitimate. But today communists are almost un- 
known. It is only with socialist arguments that we have to 
reckon; and socialists are constantly admitting both directly 
and indirectly that there is nothing inherently wrong in the 
private ownership of capital. Thus, they hold it right for 
private persons to own capital so long as the persons who do 
the owning are the laborers who use the capital for produc- 
tive purposes. Further, they expect that under socialism in- 
dividuals will be permitted to accumulate surpluses of gen- 
eral wealth, which today constitute the original form of all 
capital. Again, they constantly admit that, if the capitalist 
of today would be content to receive back what he puts into 
industry, relinquishing the surplus, no wrong would be com- 
mitted. 

But, even if the socialist should affirm that the private 
owning of capital is inherently wrong, he would find few to 
agree with him. Indeed, his assertion would be contraverted 
by his own fundamental ethical principle. For the funda- 
mental ethical principle of socialism is that each has a valid 
title to what he produces; and, though men doubtless be- 
come owners of capital through fraud, corrupt practices, gift, 
inheritance, and other non-productive methods, yet it is equal- 
ly certain that they may become, and do become, owners of 
capital by producing it. Hence on the very principles of so- 
cialism, men have a right to own capital. 

We come then to the second alternative mentioned above : 
that it is essentially wrong to permit the owners of capital to 
receive a net income from that capital. This position, like 
the first, conflicts with the fundamental principle of social- 
ism. 

In the first place, the capitalist who really produces the 
capital which he is permitted to own is, to some degree, a 
producer of the product which emerges when his capital is 
productively employed. This follows from the socialist doc- 
trine that the man who produces the capital produces the 
goods which the capital produces. But, secondly, since the cap- 



DISTRIBUTION SYSTEM DEFENDED 



513 



italist who has really produced his capital is, to some extent 
anyhow, a producer of the product which emerges when his 
capital is employed, it follows that he has a valid claim to 
some portion of that product; since producing a thing is, by 
socialist principles, precisely the ground on which a valid title 
to that thing is based. In the third place, the capitalist not 
only has a valid claim on some portion of the product emerg- 
ing from the employment of his capital, he has such a claim 
on all that portion which can properly be credited to himself, 
all which through his capital he has produced; for producing 
a commodity not only creates a valid title to that commodity, 
it is also the only thing which does so, — that is, the producer 
has a valid claim on his whole product. Hence the socialist 
assumption that the honest capitalist has a right to just so 
much of his product as will replace his capital, — no less and 
no more — is not at all what he seems to think it, an axi- 
omatic truth needing no demonstration. What the capital- 
ist really has a right to, on socialist principles, is what he 
produces through his capital. If this is less than the amount 
needed to replace the capital, he has a right to less than enough 
to replace his capital; if it is niore than enough, he has a right 
to more than enough. Accordingly, the real crux of the mat- 
ter is whether the capitalist produces through his capital more 
than enough to replace it. Has capital net productivity? 

The general question whether capital yields a net prod- 
uct could conceivably be tested in either of two ways. First, 
in a very simple economic society, it would usually be possi- 
ble to compare capitalistic and non-capitalistic methods with 
respect to their physical or technical productivity ; we could 
compare the result obtained from a certain amount of labor 
spent getting product directly with the result obtained from 
an equal amount of labor spent getting product by the capi- 
talistic method. In such circumstances, therefore, we could 
decide whether or not as a mere technical fact, the second 
or capitalistic method of using our labor gave just the same 
product as that labor would have given if used the other way. 



514 PRINCIPLES OF ECONOMICS 

or more, or less. Further, this would seem to mean that we 1 

should be able to decide whether capital just replaced itself, 
or gave more or less. A test of this kind, attempted in chap- 
ter XXIX, showed how capital under primitive conditions 
would produce enough to replace itself and something more. 

But, now, admitting that such a test would be adequate 
for primitive conditions, it certainly is not so under a devel- 
oped economic order. It could be utiHzed only in the rarest 
cases, and this for two reasons. First, speaking generally, the 
same kind of labor could not be employed indifferently (i) in 
producing a certain commodity without capital, (2 )in making 
capital, and (3) in using capital. Men do not, could not, shift 
from one kind of these productive activities to another. In 
consequence, a direct comparison of the two plans of proce- 
dure, in respect to the labor expended, is out of the question. 
Secondly, the co-operative character of most productive proc- 
esses in the present order often makes it impossible to distin- 
guish a technical product for each of the different factors in- 
volved, in other words, compels us to be satisfied with try- 
ing to ascertain the significance or importance of each factor. 

We are driven, then, to resort to a second test, namely, 
the presence or absence of an index of productivity in money 
values. We compare the money value of the cost goods util- 
ized in production and the money value of the product, as 
these money values are determined under free competition; 
and, if a surplus is disclosed, we say that capital has net or 
surplus productivity. Manifestly, it is possible to apply this 
test. But is it a valid test? Is the existence of a value sur- 
plus an unfailing index of the existence of a product or utility 
surplus? If we accept the doctrine taught in Chapter XX that 
prices necessarily tend to express marginal significances or 
utilities, we must certainly answer in the affirmative. Assum- 
ing competition among capitalists, the existence of a surplus 
value in product over costs other than waiting power proves 
that capital is economically responsible for a surplus prod- 



DISTRIBUTION SYSTEM DEFENDED 515 

uct, that is, a product in excess of the amount necessary to 
replace itself. 

The argument for this contention has already been fully 
covered in Chapter XXIX. We will add here only this much ; if 
the natural working of the laws of price cannot be trusted 
to define the real share of capital — waiting power — in produc- 
tion, the proposition assumed by the socialists that capital so 
far produces as to replace itself has no more warrant than 
our contention that it produces more than enough to replace 
itself. For, if money values do not supply a trustworthy index 
of contribution, if the quantity of product which is credited 
to capital through money values may be too large by the 
amount of the surplus, it may be too large by twice or thrice 
this much. We have no method whatever of proving that 
capital produces enough to replace itself any more than we 
have of proving that it produces enough to replace itself 
and pay 6 % also. In fact, we can go still further, and say 
that, if the money values which emerge under free competi- 
tion cannot be accepted as trustworthy indices of contribu- 
tion to product, we cannot be sure but that capital produces 
not merely a beggarly 6% surplus ; it may in fact produce a 
surplus large enough to cover the whole product. 

Thus we see that it is not possible to maintain either (i) 
that it is essentially wrong for private persons to oiun capi- 
tal, or (2) that it is essentially wrong for them to receive a 
net income from capital. There is, therefore, nothing essen- 
tially wrong or illegitimate in private interest. 

2. The Legitimacy of Private Profits 

There are no doubt many cases of profits which it would 
be difficult to defend. But profits in general, a return to the 
person who assumes the responsibility of co-operative produc- 
tion, is too plainly reasonable to merit serious discussion. 
Such persons are producers in the sense that they supply a 
condition essential to the result. They are producers in the 



5i6 PRINCIPLES OP ECONOMICS 

sense that to them some portion of the joint product is actual- 
ly imputed, as proved by the fact that they get profits. (Com- 
pare the argument for interest above.) But, if profits rough- 
ly correspond to a product of the entrepreneur, they surely 
can not be condemned as inherently wicked. Even the medie- 
val theologians, who sweepingly condemned all forms of in- 
terest-taking, permitted the taking of profits by those who 
accepted the full responsibilities and risks of an enterprise. 

3. The Legitimacy of Private Rent 

Among the several private shares into which the social 
income is divided, rent has always been the one most seri- 
ously called in question. This does not mean that profes- 
sional economists have doubted that the existence of this share 
is inevitable. The only controversy has concerned the propriety 
of letting this share go to the persons who now receive it. For 
the position which economists have only recently come to take 
with respect to interest, — that it is a natural and inevitable 
element in any economic order, — was quite early taken with 
respect to rent. We can shift the destination of rent, but we 
cannot destroy it. Rent, as an advantage derived from land 
and enjoyed by some person or persons to the exclusion of 
other persons, save in so far as it is arbitrarily redistributed, — 
rent in this sense cannot help existing. Again, the doubt as 
to the present destination of rent does not rest upon any doubt 
as to the productivity of the land from which rent is re- 
ceived, — the word "productivity" being used with the meaning 
given to it in this text. Every one admits that a portion of 
the product obtained from an industrial combination which 
utilizes a rent-bearing piece of land is automatically credited 
to that piece of land by the working of the laws of price. Ac- 
cordingly, on the basis of the ordinary doctrine with respect to 
the validity of any economic claim, it follows that, if any man 
or body of men has a valid right to own the land, such man or 
body of men has the right to receive the rent which is the 



DISTRIBUTION SYSTEM DEPENDED 



517 



product of that land. The crux of the whole matter there- 
fore is this : Can private persons acquire a valid title to land? 

We admit at once that it is more difficult to justify private 
ownership of land than that of capital. The fact that land is 
not, to any considerable degree, a produced good in the or- 
dinary acceptation of terms, shuts us out in the first instance 
from appealing to the common ethical doctrine that a man has 
a valid title to what he produces.* Doubtless special cases 
arise in which moral sentiment would recognize some service 
of discovery and appropriation as sufficiently fulfilling the 
requisite of productive action to create a title. But, broadly 
speaking, land is not a result of economic production. If, 
then, a valid title can be derived only from production, there 
can be no valid title to land either for the individual or for 
the state. 

But production is not the only adequate basis of a valid 
title. If it were, economic co-operation through exchange, 
would be impossible ; no man could devote himself to pro- 
ducing one thing, depending on exchange with other per- 
sons to supply him with other things. At present, such a 
procedure is possible, because everybody recognizes that, in 
so far as the validity of a man's title to property rests on his 
own action, exchange, carried out in good faith, gives just as 
valid a title as does production.^'^ 



* In utilizing as an ethical basis for our discussion the common 
doctrine that production gives a valid claim to goods, I do not wish 
to be understood as holding either (i) that said doctrine is unquali- 
fiedly true, or (2) that there is no other valid basis for a property- 
right in things. On the contrary, I hold that law can rightfully main- 
tain any system of property rights which is found most conducive to 
the welfare of society. It seems best, however, in meeting popular 
objections to the existing order, to argue, in so far as this is possible, 
on the basis of such fundamental principles as are accepted by people 
generally. 

** In so far, remember, as the goodness of his title depends on him- 
self. 



5i8 PRINCIPLES OF ECONOMICS 

The farmer who trades a hundred bushels of grain which 
he has produced for a horse, has now just as good a title to 
the horse as he did have to the grain ; and, if he should now 
trade the horse for a second hand automobile, he would have 
just as good a title to the automobile as he did have to the 
grain. But, in communities two or three generations old 
which maintain free trade in land, practically all the land- 
holders have acquired their landed properties through ex- 
change. It follows, therefore, that they have, generally speak- 
ing, quite as good titles to those properties as they do to the 
horses, automobiles, etc., which they have obtained through 
exchange. 

But some may object that exchange cannot give a valid 
title to anything unless the seller himself has one and, be- 
sides, has the right to transfer his title. And the seller has 
no such title or right in connection with land, for (i) ordi- 
narily the actual private owners of land have purchased from 
other private owners, and we can not assume that the titles 
of these previous owners are valid, since this would beg the 
whole question of the validity of private titles to land ; and 
(2), if we try to meet this difficulty by harking back to grants 
by the state — ^the only natural or artificial person who can 
claim a valid title, — we have to assume that said state has a 
right to relinquish its title, to alienate its property. And this 
assumption, some insist, is quite unwarranted, in that the 
state's title is that of a trustee acting for society as a whole 
or for men generally. 

The pith of this objection is contained in the second 
part; for, if the original title derived from the state were 
good, the number of subsequent exchanges whether one or one 
hundred would have no bearing on the matter. The decisive 
question, then, is this : Is it reasonable to claim with the fol- 
lowers of Henry George that the state could never rightfully 
alienate its property in land? Surely in this age there can be 
but one answer. The state as the final authority can do what- 
ever it believes to be for the highest welfare of society. It has 



DISTRIBUTION SYSTEM DEFENDED 



519 



the right to ahenate its property in land when this seems to 
be the right course, and it has equally the right to resume such 
property when that course comes to be recognized as the 
right one. In a word, the social welfare, as interpreted by 
the highest human authority — the state — is the supreme law, 
the supreme right. If a man has done his part toward gain- 
ing a valid title to land through exchange, he need not give 
himself anxiety lest the original grant of the state was in- 
valid. 

We have thus, in the foregoing discussion, defended the 
general validity of private rent, on the ground that private 
land owners have gained their titles through exchange. But 
the same facts can be interpreted in a different way, and 
when so interpreted, furnish an even better defense of pri- 
vate rent. When a man uses $2,000 to buy a piece of ground 
yielding a net income of $100, he in effect transforms that 
land into capital and its income into interest. Now, I do not 
admit that he literally makes capital of the land or interest 
of the rent. The land is still a different thing from typical 
capital ; and, in some very important relations, will continue 
to behave differently and, therefore, will need to be recog- 
nised as different. But, for our present needs, land m effect 
becomes capital. For our present needs, the real problem is 
this : What is the nature and origin of the $100 income derived 
from the given piece of land, — said income being looked at 
from the standpoint of the man who buys the land in order 
to get the income. 

From the standpoint named, this income is interest. If 
there were no such thing as interest, if the rate were zero, 
this income as a net income, would not exist. It is, indeed, 
true that the $100 would still be received by the landowner 
each year ; but what would that mean as compared with what 
actually happens now? Under the present system, he gets 
$100 each year for an indefinitely extended series of years; 
but, instead of having been obliged to pay for each of these 
$ioo's an exactly equal number of times $100, he actually 



520 PRINCIPLES OF BCONOMICS 

had to pay for it only twenty times $ioo, i. e., $2,000. If, how- 
ever, there were no such thing as interest, though he would 
still get the $100 each year, he would have been obliged to 
pay for each of these $100 an exactly equal amount, he 
would have been obliged to pay for the right to receive $100 
every year for fifty years, fifty times $100, or $5,000; for that 
right covering 100 years, one hundred times $100, or $10,- 
000; for that right covering 200 years two hundred times 
$100, or $20,000; for that right covering an indefinite period 
of years, an indefinite number of times $100. In short, he 
would get no clear income from the land, but, instead, would 
get back in an indefinite series of annual installments, exactly 
what he had put into the land in one lump sum. 

Manifestly, then, from the standpoint of a landowner who 
has bought a piece of land, the rent of the land is in effect in- 
terest. It follows that, if interest, as a type of income going 
to private persons, is legitimate, rent is also. 

But there is one more objection to be met. The critic of 
the present order may observe that, though, in the course of 
the transaction by which land changes ownership, rent is 
transformed into interest, this is only a temporary phenome- 
non. That transformation is effected because the value of the 
land adjusts itself to an income determined, not by the natur- 
al laws which govern interest, hut by those which govern 
rent. This process of adjustment for the moment establishes 
a ratio between land value and land income exactly the same 
as that which prevails between capital value and capital in- 
come. But, then, this does not really make rent into inter- 
est, nor bring it under the dominion of the natural laws which 
govern interest. The very next day, something may happen 
to double, let us say, the income from the site, therefore to 
double its value, and so to give to the owner of the land an 
income and a property to which he could lay no valid claim, 
whether we base such claims on production or exchange. 

This objection to the legitimacy of private rent sounds 
plausible; but it is not, after all, difficult to answer. Just as 



DISTRIBUTION SYSTEM DEFENDED 521 

an unchanging rent derived from a purchased piece of land 
is in effect interest, so an increase in rent derived from such a 
piece of land is in effect profits. In very fact it is profits. For, 
in accepting the responsibility of owning the piece of land, a 
man exposes himself to that risk which accompanies all own- 
ership, the risk of seeing his property fall off in income and 
so in value. To induce men to assume this risk, it is neces- 
sary that there should also be present the chance of unex- 
pected increase in income and value. When an unexpected in- 
crease comes, no new designation is needed for it ; it is simply 
profits. If, therefore, profits in general constitute a legitimate 
source of income for private persons, there is nothing inher- 
ently wrong in the so-called unearned increment of rents and 
land values. 

It is not intended to leave the impression that the legiti- 
macy of private land ownership is as clear and certain as 
that of some other types of ownership. Wherever the ele- 
ment of chance, or accident, plays a very great role, there is 
much to be said in favor of public ownership. While specu- 
lation performs a real economic function, it is in many re- 
spects hurtful and demoralizing. A socialist state would need 
it much less than does the present order, in that the pooling 
of all industries would greatly diminish the risk element. Even 
going no further than to assume the control of land would do 
much to diminish risk and its attendant evils. But, whether 
private or public ownership will in the end prove best, of 
this there can be no doubt: there is nothing inherently wrong 
in the private ownership of land and the private receiving of 
rent. 

Section D. Further Modifying Conditions of Actual Life 

Let us pause a moment now to take note of our position. 
In Section A we argued for the abstract legitimacy of the 
present principle of distribution. In Section B we showed 
that it would be legitimate in a socialistic state. In the section 



522 



PRINCIPLES OP ECONOMICS 



just concluded, we took up the task of ascertaining whether 
the principle can also be considered legitimate under the im- 
perfect conditions of real life ; and we have already observed 
its relation to one of the most important conditions, namely, 
private ownership. 

In making a truly complete critique of the existing order, 
we should be compelled to test the legitimacy of our service- 
value principle in the presence of many other modifying con- 
ditions. To carry out this test, however, would carry us far 
beyond the scope of the present volume. We shall therefore 
content ourselves with mentioning some of the conditions, 
without attempting more than the briefest comment. 

1. In Section C we merely attempted to argue for the 
general, abstract legitimacy of interest, profits, and rent as 
private shares, hamng no regard to the weaknesses of human 
nature. Taking those well known weaknesses into account, 
can the shares named still legitimately go to private persons? 
We recognize this question as a really serious one. We see 
much force in the contention that, however reasonable it may 
be on general principles to permit the private ownership of 
capital and land and the private undertaking of industry, the 
evils which inevitably result from such a policy in the actual 
working of things make its continuance impossible of jus- 
tification. Still, in view of the great superiority, in other re- 
spects, of private, to public, ownership, and in view of the fact 
that its worst evils can be gradually removed without over- 
turning the system, we believe that the system of private own- 
ership should be maintained. At the same time, however, reg- 
ulation of private initiative should undoubtedly be carried 
much further than it has been, limitations of the property 
right should be increased, and at some points, how many and 
what only experience will show, public ownership and initio^ 
tive should he substituted for private. 

2. A second supplemental question of much importance is 
whether the present system is justified in permitting private 
individuals to acquire possessions through inheritance or he- 



DISTRIBUTION SYSTEM DEFENDED 



523 



quest. Personally, I am disposed to answer this question in 
the affirmative but only with very emphatic qualifications. I 
would greatly reduce these rights both directly by legislation 
and indirectly by a taxation which, for the excess of larger 
estates over a certain minimum, would amount to practical 
confiscation. 

3. Still another question is whether law should permit 
private persons to enjoy the extraordinary profits which flow 
from the exploitation of natural resources, public franchises, 
consolidations, etc. We can only say in this limited space 
that such permission is of doubtful justice, and should at least 
be carefully guarded. 

4. Finally, how far can society afford to modify the 
primary distribution of property and income through a sec- 
ondary distribution effected by taxation? It would seem 
plain that, if the dominance of the present principle of distri- 
bution — to each in accord with the value of his service — is 
necessary to insure the proper conduct of economic affairs, we 
should spoil everything by arbitrarily contravening the work- 
ing of that principle, even though we do this after distribu- 
tion in accord zmth the principle has once been effected. For 
what interest would a man have in earning ten times as much 
as his fellows, if he is to be reduced to their level by taxation? 
Doubtless, if it were to go so far as this, he would have no 
interest in seeking the better income. But, on the other hand, 
there can be no doubt that a tax much heavier than that lev- 
ied on his poorer neighbor would not influence in any mate- 
rial degree his economic efficiency. The whole problem is one 
of degrees. Its solution probably can be reached only through 
experiment, and for that we shall have to wait. 

Conclusion 

We thus come at last to the end of the long discussion 
which has occupied the whole of this chapter and most of 
the one preceding. The purpose of these chapters has been 
to enquire whether the present economic order is a reasona- 



524 PRINCIPLES OP ECONOMICS 

bly good one from the standpoint of distribution. With all 
the facts before us, what decision may we pronounce? It 
may be doubtful whether we are justified in pronouncing any 
of a really final and unqualified sort ; but if we do pronounce 
one it seemingly must be on the whole favorable. 

Certainly the present system is not all that social minded 
men could desire; yet just as certainly it results in much that 
is desirable, and in much that could probably be realized un- 
der no other system. While it may require some change in 
details, one's reluctance to change it in fundamentals grows 
in exact proportion to his knowledge of the facts. Indeed, if 
one were to conceive of himself as a dictator in a collectivist 
state with power to replace the present regulative mechanism 
with one quite different, it is not unlikely that, — assuming his 
intentions to be really benevolent— he would choose to retain 
the present system. For he would see many reasons for be- 
lieving that, with all its defects, it not only has many good 
and redeeming points, but that it is, on the whole, the very 
best one possible. 



CHAPTER XXXV 

CRITIQUE OF THE PROCESS WHEREBY 
PRODUCTION IS REGULATED 

The chief characteristics which we can reasonably require 
in a productive system are : ( i ) that the right things shall be 
produced; (2) that the quantity of product shall be reason- 
ably large; (3) that the quality of product shall be reasonably 
good; and (4) that these results shall be realized as continu- 
ously as possible, — ^in other words, that production as a whole 
shall be as free as possible from marked irregularities. 

In the present chapter we take up the first of these re- 
quirements, — that the right thing shall be produced, or The 
Regulation of Production. 

It has by this time become a commonplace that, under the 
present order, the selection of what shall be produced is al- 
most entirely effected through freely-determined prices. Now, 
as the earlier economists taught, if the present system could 
realize fully the conditions which are assumed as fundamental 
to it, this regulative mechanism would probably be an almost 
perfect one. The spontaneous working of free competition 
would result in prices which would insure production of the 
things called for by the general advantage, — the things which 
a wise dictator dealing with the same conditions would think 
it expedient to produce. Further, the earlier economists com- 
monly believed that, even under the conditions actually exist- 
ing, price-guided production in the main, worked out re- 
sults as near the ideal as could reasonably be expected. 

In our day, this opinion is probably still held by the ma- 
jority of economists. But a not inconsiderable minority take 
radical ground on the other side. A few even insist in un- 
quahfied terms that there is no truth whatever in the older 
doctrine, that there is not even a tendency for production to 



526 PRINCIPLES OP ECONOMICS 

follow the channels which social or general advantage would 
dictate. In view of this disagreement, a careful and rather 
full treatment of the matter seems called for. We ask, then : 
Do the principles governing price promise to secure a rea- 
sonable guidance of productive activity? In answering this 
question, we will first comment briefly on the standard to be 
set up in judging whether a particular guidance of production 
is reasonable; after which we will pass in review the leading 
principles of price, and try to determine the fitness of each to 
meet this test. 

I. What Is a Reasonable Regulation of Production 

The answer to this question has already been made in in- 
troducing our critique of Distribution in Chapter XXXIII. 
The general object of an economic order of any kind is to se- 
cure the satisfaction of human wants in so far as this depends 
on economic goods. Just what wants shall be included under 
this general category, and the comparative order of their im- 
portance as between different persons, are determined by the 
system of distribution. It follows that production, like all 
other economic processes should be so regulated as to corre- 
spond to the system of distribution, — to provide for the satis- 
faction of wants according to the scale which is in effect em- 
bodied in the system of distribution. This means that, broadly 
speaking, no wants are recognized as social wants except those 
of persons having incomes under the existing system of dis- 
tribution, and that the wants of different persons have a social 
importance corresponding to the size of their incomes. Finally, 
it means that the general demand schedules made up of the 
different individual demand schedules, composite as they are, 
express the social importances of wants. 

The objection to this method of rating wants that it does 
not rate them according to their real or absolute magnitude, 
has been answered directly or by implication in the argument 
for the general reasonableness of the present system. The so- 
cial magnitude of wants is the only one in which society at 



THE REGULATION OF PRODUCTION 



527 



large is interested ; and the social magnitude of wants is hy 
no means identical with their absolute magnitude. At this 
moment, the wants of a French private may have as great ab- 
solute magnitude as those of Marshal Foch; but, quite obvi- 
ously, they have much less social magnitude. 

Another and somewhat more serious objection to the doc- 
trine before us is that, taken as a whole, it involves circular 
reasoning. On the one hand, letting ordinary demand prices — 
mere composites of heterogeneous individual schedules — rep- 
resent the social importance of wants is said to be legitimate, 
because this is the necessary complement of the system of dis- 
tribution. On the other hand, the system of distribution is said 
to be legitimate, because it gives each person what his serv- 
ices are worth as indicated by the general demand schedule. 
The system of distribution establishes the legitimacy of the de- 
mand schedules ; the demand schedules establish the legitimacy 
of the system of distribution." 

Now, this sounds plausible ; but it will not, after all, bear 
examination. It would be true only on condition that all large 
incomes were obtained by catering to the demand of persons 
of large incomes only. We should then be defending the 
power of a particular group of persons to influence unduly 
the course of production, on the ground that this was the 
necessary complement of a system of distribution which gave 
persons of that group large incomes because those persons 
supplied services which were accounted very important be- 
cause persons of that same group, having large incomes, were 
able to rate those services highly. But I hardly need say that 
no such relation exists between large incomes and their 
source. The great majority of persons in receipt of large in- 
comes get those incomes from industries which cater, not to 
the demands of large-income persons only, but rather to the 
demands of all classes. The circularity complained of is not, 
therefore, characteristic of the accepted reasoning, but only of 
special cases to which that reasoning may be applied. 

In order to emphasize the entire course of reasoning on 



528 PRINCIPLES OP BCONOMICS 

this matter let us recapitulate it in a series of propositions as 
follows : 

(i) The kind of importance in respect to wants with 
which society is really concerned and which, in the interest 
of the social welfare, should be treated as the proper guide of 
economic action is social importance. If this is not identical 
with individual or absolute importance, the latter must yield. 

(2) The social importance of the wants of different in- 
dividuals depends, not primarily on the absolute magnitude 
of those wants, but on the relative importance of the differ- 
ent social ends the attainment of which may be conditioned on 
the satisfying of those wants, and the degree to which their 
attainment is so conditioned. 

(3) One important way in which the attainment of so- 
cial ends is conditioned on the satisfying of individual wants 
is found in the fact that the getting of efficient service from 
individuals is dependent on providing for the satisfaction of 
their wants in certain proportions. If we do not provide for 
their wants in these proportions, we do not get the service 
called for. 

(4) On account of the great inequalities in human ca- 
pacity and the consequent inequalities in the importance of the 
services different men can render, it is practically indispensable 
that this satisfying of their wants on which their efficient serv- 
ice is conditioned, should have some reference to the impor- 
tance of those services, and so this satisfying of wants should 
he unequal as between different persons. 

(5) Under the present system, society elects to attain 
the end by making the money incomes of different individ- 
uals unequal and roughly adjusted to the importance of their 
services, — leaving those individuals themselves to put a rat- 
ing on the relative importance of wants. 

(6) In doing this, society necessarily recognises these 
individual ratings of the importance of ivants as social rat- 
ings, expressing the true, though indirect, social importance 
of those wants. 



THE REGULATION OP PRODUCTION 529 

(7) It thus follows that, broadly speaking, the demand 
prices of the ordinary demand schedules are, in a very real 
sense, expressions of the social importance of the wants in- 
volved. 

Having so roundly emphasized the point that the demand 
schedules resulting under the existing system of distribution 
represent broadly comparative social wants, let me once more 
remind the reader that this must be qualified if it is to be an 
entirely true account of the matter. At several points, other 
indices of the true social importance of wants are needed. The 
state must find other criteria when the wants of the group as 
a whole come into conflict with those of individuals ; when the 
needs of future generations conflict with those of the present ; 
and when the most fundamental needs of many individuals 
are opposed to the trifling needs of the few. In short, the gen- 
eral position here taken, that we must accept the demand prices 
of individuals as indices of social importance is in general per- 
fectly sound ; but, as in other cases, it is not always valid : 
these indices must at times give place to others better adapted 
for the particular case in hand. 

2. Single Price and Production 

Having now so definite a criterion as to what constitutes 
a proper regulation of production, our review of the dififerent 
laws of price which participate in this process ought to prove 
a relatively easy task. First, then, we ask : Is the law of 
single price a suitable element in the mechanism which has the 
function of regulating economic production? The answer is 
surely an affirmative one. First, it is manifest on a little reflec- 
tion that singleness of price is necessary to the realization of 
the system of distribution authorized by society. If incomes 
were equal, while the same goods had different prices, the 
equality of incomes would be defeated by indirection. One 
man could not get as much real income as another man though 
their money incomes were equal. On the other hand, if so- 



530 PRINCIPLES OP ECONOMICS 

ciety decrees inequality of income, singleness of price is nec- 
essary both from the standpoint of the man of small income 
and from that of the man of large income. If prices were 
lower to the rich man this would increase the inequality, make 
it greater than the social intention. If prices were higher to 
the rich man this would neutralize the superiority of his in- 
come. 

But there is another reason and if anything a more funda- 
mental one why the law of single price is a proper element in 
the system guiding production. It is logically essential to hav- 
ing price act as a guide at all. Guidance, like sovereignty, must 
be indivisible. One price for each product or each factor can 
guide us in the production of that product or the use of that fac- 
tor; but ^nany prices for each could not guide at all. Thus, 
if the relation of supply and demand are such that common 
sand is at the margin worth 50c while moulding sand is worth 
$1.00, these prices can perform their function in showing us 
that common sand can properly be put to uses as low as fifty 
cents while moulding sand must be reserved for uses rated as 
high as one dollar, only on condition that the one price of 
common sand is fifty cents and the one price of moulding 
sand is one dollar. If at the same time common sand has 
prices of fifty cents, seventy-five cents, one dollar, one dollar 
and a quarter, one dollar and fifty, and so on, we should have 
no guidance whatever from this source, — prices would have no 
significance as respects the importance of the things involved. 

3. Demand Prices and Production 

We have seen that the law of single price constitutes not 
only a legitimate, but also a necessary, element in an economic 
order which entrusts the regulation of production to freely de- 
termined prices. What now is to be said of those principles 
which impute to demand prices and the forces behind them, 
significance, utility, a share in the fixing of actual prices, and 
therefore in the regulation of production? Do these consti- 



THE REGULATION OF PRODUCTION 531 

tute a legitimate element in the regulative mechanism? Is it 
reasonable that actual prices which approximately equal de- 
mand prices, and approximately express marginal utilities or 
significances should participate in the guidance of production? 

In giving an affirmative answer, the majority of econo- 
mists have probably had in mind the analogy of the individual 
guiding his own economic life in accord with his individual de- 
mand schedules. With respect to the reasonableness of his 
conduct in doing this, there has been no serious difference of 
opinion. Those schedules consist of money expressions of 
utility or significance for different commodities. These money 
expressions are fairly accurate indices of the comparative im- 
portance to the individual of the utilities in question, and so 
of the goods which yield the utilities. And the function of 
such money expressions of utilities or significance is to guide 
the individual in the rational utilization of his income or re- 
sources from which to secure an income. Speaking broadly, 
each person should, as far as possible, employ his income 
or capacities for securing income in such a zvay that 
the marginal utilities of all goods secured should be equal; 
and, when this is not possible, should employ said income or 
capacities in such a way that utilities or significances of higher 
rank should never be sacrificed for utilities or significances 
of lower rank. The practical wisdom of such a rule of con- 
duct is plain, for it surely is the part of good sense to pro- 
vide for the satisfaction of our wants in proportion to their 
importance. 

Is there a true analogy between this case of the individual 
and that of society as a whole? Is there a rule analogous to 
that just laid down for the individual which can reasonably be 
applied to society as a whole ? Is it reasonable that we should, 
generally speaking, so use our resources that marginal utilities, 
as these appear to be when judged by the general demand 
schedules, shall be substantially equal all along the line? 
That such a rule for society at large actually obtains is evi- 
dent enough. That is, society's use of its income or income- 



532 PRINCIPLBS OF ECONOMICS 

bearing resources is in fact guided by the market demand 
schedules which were studied in earlier chapters. Through 
the guidance of these schedules, resources are so employed that 
the marginal want satisfied in any one of many different lines 
is equal, — when measured by the persons interested, in a m-it 
which is at least nominally the same, — to the marginal want 
satisfied in any other of those different lines. In other words, 
if we recognize demand prices as a true index of the size of 
wants, then $i's worth of resources are used to satisfy what 
seem to be $i wants, not 50 cent wants nor $2 wants. But, 
while such a rule does obtain for society in general, the ques- 
tion remains whether this rule can be interpreted and justified 
as the analogous rule is in the case of the individual. Are these 
demand prices of the general demand schedules a true index 
of the real social magnitude of wants? Do they express com- 
parative social or general importances in anything like the same 
way that the demand prices of the individual schedule express 
comparative individual importances? If they do, — and only if 
they do — we may say that the guidance of production effected 
through them in a rough way secures the gratification of wants 
in proportion to their importance, and is, therefore, a reason- 
able one. 

This question has already been answered in the affirmative 
on page 255. Given a system of distribution approved by 
society (and a system of distribution cannot exist without this 
approval), the general demand schedules are social schedules, 
schedules representing social significances or importances, as 
these are determined by the vast complex of conditions which 
at any moment prevails. To this broad statement, there are 
several qualifications, as already brought out ; but the statement 
is, after all, substantially true. The objection, that, on account 
of the different meanings of the money measure to different 
persons, the prices of the general demand schedule do not rep- 
resent the absolute magnitude of wants, has already been suf- 
ficiently well answered. The reasonable, the proper, guide to the 
use of the resources belonging to a social group is not the abso- 



THE REGULATION OP PRODUCTION 533 

lute magnitude of wants hut their social magnitude. Production 
should be so guided as to secure the greatest social, not indi- 
vidual, advantage. We are not, therefore, concerned with ab- 
solute magnitudes. 

If the objection is to be interpreted as really directed 
against the use of the term "utility" and the phrase "maginal 
utility" in this connection, the matter, like other verbal con- 
troversies, is not of great moment. The general point, how- 
ever, is important. In accepting the guidance of ordinary de- 
mand schedules in the use of its resources, society, broadly 
speaking, insures that those resources shall he used in a way 
which provides for the satisfying of zvants in proportion to 
their social significance. 

4. Cost-Determined Price and Production 

Among the most important of the principles through which 
prices are determined are those which affirm some kind or de- 
gree of causal connection between price and cost of produc- 
tion. Broadly speaking, in most cases prices have to equal mar- 
ginal cost of production ; or, anyhow, the prices of different 
goods have to show the same ratios as their costs of produc- 
tion. A commodity costing twice as much as some other com- 
modity must have a price approximately twice as high. Is such 
a principle as this a suitable element in the mechanism which 
regulates production? Does it tend to insure that our re- 
sources shall be most wisely utilized? 

Here, again, the answer is certainly an affirmative one. 
Prices which have the regulating of production, which are 
called on to utilize our resources to the best advantage, can 
do this only on condition that they are, generally speaking, 
coincident with marginal cost. Correct prices, prices fitted to 
guide production rightly, must be adjusted, not only to demand 
prices and the forces behind them, but also to supply prices. 
If the price of any particular commodity, as compared with 
those of other commodities, was higher than its cost, this could 



534 



PRINCIPLES OF ECONOMICS 



be only because that price was being held up by a marginal 
significance or utility abnormally high as compared with that 
of other commodities having the same cost. But, since it is our 
business so to use our productive resources that a given unit 
of those resources yields equal or almost equal marginal utili- 
ties all along the line, the abnormally high marginal utility of 
our special commodity would mean that too little of our re- 
sources was being used in the production of that commodity, 
too much in the production of other commodities. On the 
other hand, if the price of any particular commodity, as com- 
pared with those of other commodities, was below its cost of 
production, this could be only because that price was being 
held down by a marginal significance or utility which was ab- 
normally low as compared with that of other commodities hav- 
ing the same cost. But, in view of our rule of equal marginal 
utilities, this abnormally low marginal utility of our special 
commodity would mean that too much of our resources was 
being used in its production, too little in the production of 
other commodities. 



CHAPTER XXXVI 

CRITIQUE OF PRODUCTION IN RESPECT 
TO EFFICIENCY 

In beginning the last chapter we said that a satisfactory- 
economic order might reasonably be expected to produce the 
right things, to produce them in large quantity, to produce 
them of excellent quality, and to produce them without 
marked irregularities. We have thus far seen that the existing 
order, governed as it is by the laws of price, meets the first of 
these conditions — the production of the right things — reason- 
ably well. It is the task of the present chapter to make a 
similar, though briefer, test of the three remaining conditions. 

I. The Present Order and a Large Volume of 
Products 

To the question whether the present order is fitted to make 
the volume of products large, almost all students of our sub- 
pect give a favorable answer. In general, abundance of prod- 
ucts must depend chiefly on three conditions : ( i ) a large vol- 
ume of productive factors, (2) high efficiency in those fac- 
tors, and (3) most profitable utilizing of those factors. Let 
us consider these in order. 

As respects the volume of resources, no system can alter 
this as far as it depends upon nature. But the factors de- 
pendent on human choice, — all forms of labor, waiting, and 
initiative or responsibility-taking, — may be supplied in small 
or in large volume according to conditions. As regards the 
second and third, the present order promises to do much bet- 
ter than any substitute ever seriously considered. A large 
volume of capital, which is the sole condition for an abundant 
supply of waiting power and the principal one for an abun- 
dant supply of initiative, is surely more likely to be realized 



536 PRINCIPLBS OF ECONOMICS 

under the present order than under socialism. With the pres- 
ent order, the accumulation of capital is left to private ini- 
tiative, and a reward offered, in the shape of interest and 
profits, makes possible the attaining of a competency with its 
freedom from labor. Under socialism, private capital, any- 
how private interest and profits, would be eliminated. Society 
would, therefore, have to depend on something akin to taxa- 
tion as a means for accumulating capital. But in a demo- 
cratic state, with inequalities of income eliminated or much 
reduced, it is hard to believe that capital could be largely ac- 
cumulated by such a method. 

Turning to the labor factor, we must admit that a social- 
istic order would show less difference; but it would after all 
give smaller resources than the present order. One of the 
leading aims of socialism is to diminish individual responsi- 
bility in economic things. It does not, indeed, plan to go as 
far as communism, treating all members of the community as 
if they were members of one common family, — insuring them 
a livelihood anyhow. But it does propose to go a long 
way in this direction, — to insure every one a job and a 
so-called living wage, — to relieve every one of much of the 
anxiety which characterizes the present order. Now, this may 
be on the whole very desirable ; but it can scarcely fail to re- 
duce the energy, industry, alertness, and prudence, which men 
bring to their tasks under the present order where the liveli- 
hood and the economic position of each individual is condi- 
tioned on the contribution he makes to the supposed welfare 
of his fellows. 

What has been said concerning the volume of the factors 
available applies in considerable measure to their efficiency. 
That feature of the present order which makes the share of 
each person dependent on his contribution as measured by 
others, stimulates him — assuming free competition — to raise 
the efficiency of the factor in his control as high as possi- 
ble, in other words, to furnish efficient services. Finally, the 
system of private initiative probably promises to give greater 



CRiTlQUn OF PRODUCTIVE EFFICIENCY 537 

efficiency in the utilization of the factors ; though it is doubt- 
less true that governmental action can contribute much at this 
point, particularly by the discovery of better methods in in- 
dustries where private initiative seems backward. In general, 
then, we may conclude that under the present order all the 
necessary conditions are fulfilled for securing a large volume 
of products. 

The above verdict is concurred in by almost all econo- 
mists. Yet perhaps a moment should be given to the oppo- 
sing contention or certain critics that the present order is not 
productively successful. In support of this idea they bring 
forward three considerations chiefly : the wastes of competi- 
tion, the idleness of the parasitic classes, and the sacrifice of 
utility to value. 

The first of these points is easily answered. There are 
undoubtedly wastes in a system of free private initiative, — • 
though their amount is grossly exaggerated, — but, in the opin- 
ion of the economist, this so-called waste is merely the cost 
of a rarely efficient initiative, and a low cost at that. For 
all students of business organization agree that the monopo- 
listic and quasi-monopolistic business units are much less effi- 
ciently organized today than are the units exposed to free 
competition. 

Again, we cannot take more seriously the talk about the 
wasted productive capacities of the parasitic classes. To start 
with, their number is extremely small. A large proportion of 
the persons often designated as parasites are in fact per- 
forming functions essential to high productive efficiency. In 
the second place, it seems certain that, if they all were to be- 
come producers in the socialist sense, the amount they would 
add to the income of each person would be scarcely apprecia- 
ble. 

Finally, the third objection of the socialist seems to econo- 
mists to be a serious error. There is no doubt the possibility 
of a contradiction between utility and value. One who is 
seeking only to increase values may find himself in a posi- 



538 PRINCIPLES OF UCONOMICS 

tion where he would better diminish output and so diminish 
utilities ; and, since the immediate return to producers is a 
value return, (purchasing power in the form of money) rather 
than a utility one, it naturally follows that producers may at 
times gain most by reducing, or at least checking, the increase 
of utilities. But the pursuit of such a policy is possible only 
through concert of action among producers; since values can 
be increased by limiting output, only provided it is the total 
output which is thus limited, not merely that of some pro- 
ducers. But concert of action among producers is in contra^ 
diction to the very essence of the present order of which un- 
trammeled private initiative is the dominant feature. Accord- 
ingly, it is quite illegitimate to represent this order as one in 
which producers will inevitably seek to increase values to the 
neglect, or even the destruction, of utilities. Increase of val- 
ues is doubtless the natural goal of the producer as producer ; 
but, under a regime of free competition, the only path by 
which that goal, generally speaking, can he attained is the in- 
crease of utilities j^ 

2. The Present Order and Qualitative Excellence in 
Products 

The third requisite of an effective regulative mechanism 
for an economic order is fitness to insure that products should 
be of high quality as well as abundant in quantity. Is this 
requisite likely to be present in a regulative mechanism which 
consists of freely determined prices? At this point, it seems to 



* The last objection is perhaps given too little weight in view of 
the present trade-union policy of encouraging or requiring the limita- 
tion of output, — a policy which would probably be less pronounced 
under socialism than it is today. Doubtless the diminution or disap- 
pearace of the open approval of soldiering would tend to result in a 
considerable increase in output. On the whole, however, I believe that 
this would be more than offset in a socialist order by the diminution 
in motive for effort due to the much less rigid connection between 
wage received and service rendered. 



CRITIQUE OF PRODUCTIVE EFFICIENCY 539 

me, our verdict cannot be so favorable. Doubtless the dis- 
criminating demands of buyers will secure high quality in 
some few products, through the natural competition of pro- 
ducers. But with the majority of products this rule will not 
apply. Unless government steps in to supplement the con- 
trol effected by freely-determined prices, we almost every- 
where meet with adulteration, poor materials, bad workman- 
ship, etc. This might be remedied if buyers became more 
alert, better-informed, and more insistent with regard to their 
rights. But the likelihood of any such change is very re- 
mote. At many points buyers would find great difficulty fit- 
ting themselves to guard their interests even were they dis- 
posed to take the trouble; at some others they are pretty 
likely to be misled despite their efforts. Much evil may thus 
result both to individuals and the community ; so we cannot 
afford to leave regulation to the working of spontaneous forces. 
It should be added, however, that the partial failure of price 
control in this respect does not constitute a very serious defect 
in the present order, because the needed supplemental action 
of government is comparatively easy to work out, as has been 
shown by the experience of the last sixty years in England. 

3. The Present Order and Continuity of Production 

An economic order in which the regulative mechanism 
was efficiently operative for short periods only, — being every 
now and then completely thrown out of gear so that a highly 
disordered state of things ensued, — would be considered by 
every one seriously defective, if not almost unendurable. An 
economic order to be really satisfactory, ought to show 
steadiness, regularity, dependableness, — ought to be free from 
all marked perturbations. Now in this respect, our system 
unfortunately does not work so well as we might desire. It 
is a familiar fact that production is subject to marked, almost 
violent, fluctuations, which naturally group themselves into 
the so-called industrial cycle ; depression, recovery, increasing 



640 PRINCIPLBS OP ECONOMICS 

activity, normal activity, over-trading, crisis, collapse, de- 
pression, and so around again. The claim of the socialist 
that public initiative would almost, if not quite, eliminate this 
sort of thing is without doubt a fairly reasonable one. At all 
events, socialism would be certain to work better at this point 
than does the present system. The fact, however, is that the 
industrial cycle, in its serious forms, is a comparatively mod- 
ern disease, little more than a century old ; and much has 
already been done by our system to bring it under con- 
trol. America, for reasons easy to trace, is still much subject 
to attack. But England, the original home of great panics, 
has had no serious crisis since 1866. In short, the leaders of 
industry are learning to control things sufficiently to safe- 
guard this trouble or to palliate greatly its evils. Accordingly, 
while the present order cannot be cleared of blame, we would 
surely be unjustified at the present time in pronouncing a final 
verdict against it on account of the defect in question. • 

Conclusion 

We set out upon this discussion by asking whether the 
principle of price regulation works out reasonably satisfactory 
results in respect to production. What answer may we draw 
from the facts presented above ? We may, and apparently are 
compelled, to draw an affirmative answer — an affirmative qual- 
ified, but still an affirmative. The principle is perhaps below 
the best one conceivable. Nevertheless, while great improve- 
ments are needed, are possible, and ought to be effected, we 
must still hold that a verdict for the substantial soundness of 
the principle is practically inevitable. Again we may say, as 
we did at the close of our critique of distribution, that a thor- 
oughly humane despot with power to substitute any other prin- 
ciple thus far proposed, might very probably — if he took all 
the facts into consideration — decide that the principle now 
operative was on the whole the very best one possible. 



CHAPTER XXXVII 

CRITIQUE OF CONSUMPTION 

In concluding our study, let us consider for a moment the 
satisfactoriness of the present order with respect to Consump- 
tion. Consumption, sometimes treated as one of the main di- 
visions of Economics, co-ordinate with production, exchange 
and distribution, has for various reasons been given little prom- 
inence in this volume. Nevertheless, our critique of the pres- 
ent order ought not to end without a brief comment on the 
way in which the price regulative feature affects consump- 
tion — the use which is made of wealth — and without some at- 
tempt to determine whether the result is satisfactory or the 
reverse. 

As respects the regulation of consumption, a satisfactory 
system needs to show three results chiefly : ( i ) Those natural 
resources which belong to society as a whole and to posterity 
must not be sacrificed to the selfish greed of the individual 
and the present; (2) The satisfaction of immediate wants 
must not absorb all our producing efforts to the neglect of 
that building of capital on which great productive efficiency 
depends; and (3) The best utilization of a stock of consump- 
tion products already existing should be assured. 

The first of these demands, we must admit at once, is very 
imperfectly provided for in the present order. Under the 
free working of private initiative, the vast resources of a 
continent in lumber, coal, iron, etc., are being rapidly dissi- 
pated, and that in too large measure for the benefit of very 
small classes. Even the race itself has been threatened with 
serious deterioration through an unbridled use of liberty in 
the employment of women and children; so that everywhere 
governmental interference has proved a necessity. All this is 
natural enough. When we are dealing with the interests of 



542 PRINCIPLES OF ECONOMICS 

the remoter future, it is only within quite narrow limits that 
we can trust the forces which ordinarily prove efficient and 
safe regulators of economic action. The safe-guarding of 
those interests is a duty which from its very nature rests up- 
on the group, rather than the individual. Unfortunately, the 
group too rarely rises above the standpoint of those individ- 
uals who are economically most powerful and greedy; so 
that the duty of the group in this respect is too frequently neg- 
lected. Still it cannot be doubted that our only hope lies in 
this direction. Government must put great and rigid limita- 
tions on private initiative if the social patrimony is to be saved 
at all. 

As regards the second requisite of a system which prop- 
erly regulates consumption — that it should not permit the sat- 
isfaction of immediate wants to absorb all our productive ef- 
forts to the neglect of capital-building — our present system 
can give an excellent account of itself, — a better account, 
probably, than could be given by any system depending on 
public initiative. Capital increases at an amazing pace. The 
increase is doubtless not a little due to a feature of the system 
which is, in many respects, undesirable, the extreme inequal- 
ity of incomes ; for this concentrating so much in the hands 
of a few makes the task of saving relatively easy. But there 
is another explanation. The present system powerfully stim- 
ulates accumulation in that it offers to those who save, great 
rewards, not so much in the shape of interest, as in the shape 
of those profits which may be obtained by the skillful use of 
a small initial sum. A further reason is found in the fact 
that the present system supplies highly convenient and effi- 
cient machinery for assisting the process of capital-building, 
in the shape of savings banks, insurance companies, bond ex- 
changes, and the like. 

The third requisite, — the best utilization of an already 
existing stock of consumption products, — is easily met by the 
present system, save under quite exceptional circumstances. It 
belongs to the very nature of the laws of exchange to estab- 



CRITIQUE OF CONSUMPTION 543 

lish a price which adjusts demand to stock: reducing demand, 
if stock is deficient, by raising price, increasing demand, if 
stock is excessive, by lowering price. But here, again, we are 
confronted with the "rich-man-poor-man" objection which 
was brought forward against the present regulation of pro- 
duction. "Demand," it is said, "is doubtless adjusted to stock 
by being cut down through higher price ; but unfortunately 
this means that the demand of the poor is reduced while 
that of the rich remains at its old level." Now, there is doubt- 
less some truth in this ; the burden of curtailing consumption 
will often fall more on the poor than on the rich. Further, 
just as in production, circumstances may arise where the dis' 
crepancy between the real magnitude of wants and their ef- 
fective magnitude as expressed in price is so great that it be- 
comes the duty of society to interfere with the automatic reg- 
ulation and determine by authority the destination of its re- 
sources. Thus, when a famine of food, fuel, or other fun- 
damental necessary threatens, it usually becomes the duty of 
government to intervene, even perhaps to the extent of tak- 
ing upon itself the task of distributing these commodities. 

But, while extraordinary circumstances may arise which 
call for some other method of regulating consumption, the 
regulation by freely-determined price is on the whole fairly 
well adapted to most needs of human society. In the first 
place, it is easy to exaggerate the seriousness of the objec- 
tion that in times of stock-deficiency, regulation through price 
throws the entire burden of curtailing consumption on the 
poor. Save with respect to a very few commodities, indeed, 
the number of families who do not reduce consumption at all 
when price rises is very small, — so small that its continuance 
of the old scale cannot materially alter the result; and here 
the government should, and usually does, step in and adjust 
the matter. In the second place the maintenance of a con- 
sumption policy which treats wants as having a social im- 
portance corresponding, not to their absolute magnitude, but 
rather to their apparent magnitude as expressed in the de- 



544 PRINCIPLES OP ECONOMICS 

mand schedules of individuals, is a necessary complement to 
the system of distribution which is permitted to obtain. If 
incomes can legitimately be unequal, — and we have argued 
that they really must be unequal, — ^the needs of persons hav- 
ing unequal incomes, needs which are, absolutely considered, 
equal, must, after all be treated as having unequal social im- 
portances. For any other policy would destroy the inequality 
of incomes which, by hypothesis is necessary. 



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